(Lecture Notes in Economics and Mathematical Systems) Sebastian Rausch - Macroeconomic Consequences of Demographic Change - Modeling Issues and Applications-Springer (2009)

Lecture Notes in Economics
and Mathematical Systems 621

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Editorial Board:
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Sebastian Rausch
Macroeconomic Consequences
of Demographic Change
Modeling Issues and Applications
123
Dr. Sebastian Rausch
Postdoctoral Associate
Joint Program on the Science and Policy
of Global Change
Massachusetts Institute of Technology
77 Massachusetts Ave, Bldg E19-439a
Cambridge, MA 02139-4307
USA
ISSN 0075-8442
ISBN 978-3-642-00145-1 e-ISBN 978-3-642-00146-8
DOI 1 0.1007/978-3-642-00146-8
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To My Parents
Preface
This book represents a culmination of my Ph.D. research conducted at the Ruhr

Graduate School in Economics and at the University of Duisburg-Essen from Octo-
ber 2005 to April 2008. Many people have generously contributed their time, expe-
rience and resources towards the success of this dissertation.
First and foremost, I would like to thank Prof. Dr. Volker Clausen, a great super-
visor, who has always encouraged my work. It has been a pleasure to work under his
excellent guidance. His steady engagement and support have provided me the kind
of working environment that has proved to be instrumental in writing this thesis. I
am also grateful to my second supervisor, Prof. Dr. Thomas F. Rutherford, who has
inspired my work from the beginning. This thesis would definitely not have been
possible without his innumerable and fundamental contributions in the area of com-
putational economics. As a co-author of Chapter 2 of this thesis, he was a pleasure
to collaborate with and learn from.
Many additional people have been a source of encouragement, providing helpful
conversation, thoughtful advice and valuable feedback. Thanks go to my fellow doc-
toral students at the Ruhr Graduate School in Economics, and my colleagues at the
University of Duisburg-Essen. Moreover, I would like to express my gratitude for
the efforts of my teachers in the doctoral program of the Ruhr Graduate School in
Economics which both shaped my research and helped me become a more versatile
economist. I gratefully acknowledge the generosity of the Ruhr Graduate School in
Economics and the Alfried Krupp von Bohlen and Halbach Foundation throughout a
research grant and the funding of several presentations at international conferences.
Finally, I cannot finish without saying how grateful I am to my family and my
friends for all their support during the years of my dissertation. I am deeply indebted
to my parents for their love and dedication during all stages of my life which has
given me the opportunity to come so far in the first place. To them I dedicate this the-
sis. Last but not least, I am sincerely thankful to my wife Angelika for her unfailing
patience and cheerful support throughout which made all this possible.
Cambridge, Massachusetts, USA

February 2009 Sebastian Rausch
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Macroeconomic Consequences of Demographic Change: Focus
and New Aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.1 Global Demographic Change and International Trade . . . . . . 7
1.2.2 Quantifying the Sectoral and Distributional Effects of
Population Aging in Germany . . . . . . . . . . . . . . . . . . . . . . . . . 8
2 Computation of Equilibria in OLG Models with Many

Heterogeneous Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 Calibration in CGE models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.2.1 CES Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.2.2 The Calibrated Share Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.3 CGE with Many Households: A Decomposition Approach . . . . . . . . 17
2.3.1 A Static Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.3.2 A Decomposition Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.4 Convergence Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.4.1 Local Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.4.2 Global Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.5 OLG Models with Many Households . . . . . . . . . . . . . . . . . . . . . . . . . . 28
2.5.1 A Prototype Auerbach-Kotlikoff OLG Model . . . . . . . . . . . . . 28
2.5.2 A Decomposition Algorithm for OLG Models . . . . . . . . . . . . 31
2.5.3 Algorithmic Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.6 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3 Trade Liberalization and Global Demographic Change: A

Quantitative Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.2 Model Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.2.1 Heterogeneous Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
x Contents
3.2.2 Firms and Production Structure . . . . . . . . . . . . . . . . . . . . . . . . 50

3.2.3 Feasibility Conditions and Model Closure . . . . . . . . . . . . . . . . 51
3.2.4 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3.3 Calibration and the Nature of Demographic Shocks . . . . . . . . . . . . . . 53
3.3.1 Calibration Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
3.3.2 Region-specific Population Dynamics . . . . . . . . . . . . . . . . . . . 56
3.4 Model Results and Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.4.1 Demographic Change in a Two-Sector Economy Under
Autarky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.4.2 Globally Unsynchronized Aging Patterns and International
Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.4.3 Welfare Effects of Trade Liberalization Under Global
Demographic Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
3.4.4 Aggregate Social Welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.4.5 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
3.5.1 Steady State Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
3.5.2 Solution Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
4 Quantifying the Sectoral and Distributional Effects of Demographic

Change in Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.2 Model Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
4.2.1 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.2.2 Foreign Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
4.2.3 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
4.2.4 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.2.5 Market Clearing Conditions and Model Closure . . . . . . . . . . . 94
4.2.6 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
4.3 Calibration and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
4.3.1 Numerical Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
4.3.2 Thought Experiment and Calibration of the Model . . . . . . . . 98
4.3.3 Input-Output Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.3.4 Representation of the Household Sector . . . . . . . . . . . . . . . . . 100
4.3.5 Demographic Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
4.3.6 Calibration of Free Parameters . . . . . . . . . . . . . . . . . . . . . . . . . 102
4.3.7 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.4 Results of the Benchmark Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.4.1 Macroeconomic Effects of Population Aging . . . . . . . . . . . . . 104
4.4.2 Sectoral Change During the Demographic Transition . . . . . . 106
4.4.3 Distributional and Welfare Consequences of the
Demographic Transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
4.5 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Contents xi
4.5.1
Age-specific Preferences: How Important Are Structural
Changes in Final Consumption Demand ? . . . . . . . . . . . . . . . . 114
4.5.2 Piecemeal Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 117
Appendix 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Appendix 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
5 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
List of Figures
2.1 Solution to the initial representative agent model (Step 0 and Step 1) 19
2.2 Evaluating household demands at new prices (Step 2) . . . . . . . . . . . . . 20
2.3 Recalibration of preferences (Step 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.4 Iterative adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.5 Comparison of SR and tâtonnement fields . . . . . . . . . . . . . . . . . . . . . . . 26
2.6 Global convergence behavior for different configurations of θ and σ . 27
2.7 Solving OLG by Ramsey: steps in the decomposition algorithm . . . . . 31
2.8 Approximating OLG by Ramsey: the issue of terminal generations . . 34
2.9 Solving OLG by Ramsey: sequence of investment time paths . . . . . . . 38
2.10 Solving OLG by Ramsey: sequence of welfare changes by generation 39
2.11 Solving OLG by Ramsey: approximation error ek . . . . . . . . . . . . . . . . . 40
3.1 Unsynchronized global aging patterns . . . . . . . . . . . . . . . . . . . . . . . . . . 44

3.2 Calibrated life cycle behavior for h = 3 (initial steady state) . . . . . . . . 54
3.3 Baseline equity shares by household type and age . . . . . . . . . . . . . . . . 55
3.4 Demographic shocks and population aging . . . . . . . . . . . . . . . . . . . . . . 56
3.5 Per capita macroeconomic variables under autarky . . . . . . . . . . . . . . . 58
3.6 Sectoral change and impact on equilibrium commodity and factor
prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3.7 Intergenerational distribution of welfare effects by household types . . 62
3.8 Intragenerational distribution of welfare effects (for g = 5) . . . . . . . . . 62
3.9 Factor price changes and impact on household decisions (trade vs.
autarky) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.10 Sensitivity of social welfare changes to inequality parameter . . . . . . . 66
3.11 Sample frequency distribution of per capita capital stock . . . . . . . . . . . 69
3.12 Sample frequency distribution of welfare gains from trade
liberalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4.1 Evolution of working-age population ratio and population growth rate 82

4.2 Nesting structure of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.3 Utility nesting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
xiv List of Figures
4.4 Evolution of income inequality (all households) . . . . . . . . . . . . . . . . . . 110

4.5 Evolution of intergenerational income inequality . . . . . . . . . . . . . . . . . 111
4.6 Evolution of intragenerational income inequality . . . . . . . . . . . . . . . . . 112
List of Tables
2.1 Convergence performance and approximation error . . . . . . . . . . . . . . . 41

2.2 Approximation errors for different Γ . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
2.3 Convergence behavior in the presence of strong income effects . . . . . 42
3.1 Base case parametrization of intracohort household heterogeneity . . . 53

3.2 Sensitivity of per capita variables under autarky . . . . . . . . . . . . . . . . . . 68
3.3 List of variables and parameters (household calibration model) . . . . . 79
3.4 List of variables and parameters (“related” Ramsey optimal growth
problem) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.1 Inequalities and associated complementary variables . . . . . . . . . . . . . . 97

4.2 Industrial sector aggregates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.3 Household characteristics according to EVS . . . . . . . . . . . . . . . . . . . . . 101
4.4 Impact of population aging on key aggregate statistics (benchmark
model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
4.5 Sectoral change due to population aging (benchmark model) . . . . . . . 106
4.6 Impact of population aging on sectoral employment and capital use . 108
4.7 Welfare consequences of population aging (equivalent variation in %) 113
4.8 Age-specific distribution of consumer spending across sectoral goods 114
4.9 Impact of population aging on key aggregate statistics (model with
age-specific preferences) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
4.10 Sectoral change due to population aging (model with age-specific
preferences) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
4.11 Piecemeal sensitivity analysis (benchmark model) . . . . . . . . . . . . . . . . 119
4.12 Overview of model parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.13 Intermediate demand structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
Chapter 1
Introduction
The world is in the midst of a major demographic transition. Not only is the popu-
lation growth slowing, but the age structure of the population is changing, with the
share of the young falling and that of the elderly rising. The sources of population
aging lie in two demographic phenomena: rising life expectancy and declining fer-
tility. Population aging is most advanced in the industrialized countries but, with
a lag, demographic trends in many developing economies will follow (United Na-
tions, 2006). Because many developing countries are experiencing faster fertility
transitions, in the future they will experience even faster population aging than the
currently developed countries (Bloom and Williamson (1998) and Weil (2006)).
In the coming decades, this demographic transition will prove to be a key factor in
the development of societies. From a macroeconomic perspective, the consequences
of population aging are substantial and manifold. For example, a lower growth in
the working age population causes aggregate labor supply to decline and reduces
the amount of investment required to supply new workers with capital. As a result,
capital becomes abundant and labor becomes scarce with ensuing changes in factor
prices and interest rates (Krueger and Ludwig, 2007). Börsch-Supan (2003) argues
it is unlikely that the decline in the labor force will be offset by higher capital in-
tensity to prevent adverse effects on domestic production. This will have significant
impacts on labor markets (Börsch-Supan, 2003) as well as capital markets (Kot-
likoff, Smetters and Walliser, 2001) influencing savings and investment behavior
and ultimately the growth rate of the economy (Batini, Callen and McKibbin, 2006).
Demographic change also interacts with public policies through various channels.
Most obviously, rising old age dependency ratios jeopardize the sustainability of cur-
rent social security systems (Abel, 2003). Burtless (2006) calculates that the effect
of population aging would significantly raise tax rates required to finance increased
government spending. With respect to goods markets, populating aging is bound
to change the composition of aggregate demand thereby changing relative prices
(Lührmann, 2005).
While this list of consequences is not by any means exhaustive, an abundant body
of literature has scrutinized many of the possible effects of demographic change;
see, e.g., Börsch-Supan (2004) for an overview. In order to quantify these effects
S. Rausch, Macroeconomic Consequences of Demographic Change, 1

DOI: 10.1007/978-3-642-00146-8_1, © Springer-Verlag Berlin Heidelberg 2009
2 1 Introduction
computable overlapping generations (OLG) models have emerged as the dominant

analytical tool.1 This book is related to the literature that uses OLG simulation mod-
els to study the economic consequences of demographic change. Its contribution
is twofold. Firstly, it puts forward a new computational method that can be used
to effectively solve large-scale OLG models. Unlike existing solution methods, the
presented algorithm allows to solve high dimensional models that can incorporate
a large number of heterogeneous households, many sectors and many regions. This
significantly increases the range of economic questions that can be addressed with
such models, hence providing a valuable addition to the toolbox of applied general
equilibrium modelers. Secondly, the new computational method is applied to inves-
tigate hitherto unexplored aspects of the macroeconomic consequences of demo-
graphic change. The first of two applications investigates the interrelation between
globally unsynchronized aging patterns and international trade and, moreover, looks
at the distribution of gains from trade under such demographic circumstances. The
second application takes a more detailed view at the economic adjustments within
a country that are brought about by the ongoing and projected aging processes. To
this end, a quantitative model is calibrated for the German economy to evaluate the
effects on the sectoral composition of output. One integrated feature of the models
presented in this book is—by virtue of the new computational method—to also look
in-depth at the distributional implications of demographic change for income and
welfare, both on intra- and intergenerational household levels.
Starting with the seminal work by Auerbach, Kotlikoff and Skinner (1983) and
Auerbach and Kotlikoff (1987), computable OLG models have become an impor-
tant tool for policy analysis, fruitfully applied in fields such as macroeconomics and
public finance.2 Apart from generic advantages of rigorously micro-founded gen-
eral equilibrium models, of which OLG models are a special case, these models are
appealing for at least three reasons. Firstly, they depart from the uncomfortable as-
sumption of infinitely lived agents in the standard neoclassical growth model (Ram-
sey (1928), Cass (1965), and Koopmans (1965)) by assuming that economic agents
have a finite lifetime. This implies a turnover of the population as at any point in
time a new generation is born and an old one exits the model. Most importantly,
this feature enables the study of intergenerational distributive effects of economic
policies, making the OLG model a natural framework within which to investigate
demographic issues. Secondly, by capturing the essence of the life-cycle theory of
consumption and saving introduced by Modigliani and Brumberg (1954) and Ando
and Modigliani (1963), OLG models allow to investigate the aggregate implications
of life-cycle saving by individuals.3 Thirdly, within the class of dynamic general
1 For surveys of econometric studies that deal with demographic change see, e.g., Bryant and
McKibbin (1998, 2003).
2 See Kotlikoff (2000) for an overview. The basic model in which households live for two periods
goes back to Allais (1947), Samuelson (1958), and Diamond (1965).

3 OLG models provide an example of economies in which the competitive equilibrium may not
be Pareto-optimal: life-cycle savers may overaccumulate capital, leading to equilibria in which

everyone can be made better off by consuming part of the capital stock (see, e.g., Phelps (1961)
and Diamond (1965)). This possible deficiency contrasts sharply with the intertemporal efficiency
1.1 Methodology 3
equilibrium models, the OLG framework is a natural candidate for introducing het-
erogeneous agents into the economic analysis. By construction, OLG models feature
heterogeneity of age among agents, and adding intra-cohort heterogeneity to these
models involves a—more or less—trivial indexing of agents within each generation.
Advancing numerical OLG models in this direction is clearly desirable because it
strengthens the micro-foundation of this type of analysis, and allows to analyze in
more detail the distributional implications of economic policy. Not surprisingly, this
is an active area of research. In a considerable number of papers, e.g., Conesa and
Krueger (1999), Kotlikoff, Smetters and Walliser (1999), Krusell and Smith (1998)
Huggett and Ventura (1999), Jensen and Rutherford (2002), Krueger and Ludwig
(2007) and Storesletten, Telmer and Yaron (2007).
1.1 Methodology
Large-scale OLG models have been fruitfully used to analyze a wealth of economic
issues, as for example tax reform, investment incentives, government spending and
debt, social security reform, monetary policy, endogenous growth, human capital ac-
cumulation, and demographic change. However, the scope in many applications and
the required degree of complexity are often limited by the computational power of
available numerical solution techniques. Quantitative simulation models with over-
lapping generations naturally involve a large number of variables and equations that
describe the equilibrium behavior of economic agents and the aggregate economy. In
particular, models that exhibit a rich household side including a variety of household-
specific effects, a large number of heterogeneous households, and realistic lifetimes
of agents, typically require “customized” solution methods that may both be costly
to implement and difficult to validate. Under such circumstances, the decision to add
specific features to the model may not be driven by economic reasoning alone but
also by the need to take into account the computational feasibility of the numerical
problem.
Chapter 2 of this research monograph, written with Thomas F. Rutherford, aims
at remedying this problem by developing a new decomposition algorithm that can
be used to efficiently solve large-scale OLG models. The algorithm can be imple-
mented using “off the shelf numerical tools” which are routinely available through
GAMS.4 The presented approach is primarily appropriate for computing equilibria
in models in which the number of agents is so large that simultaneous solution meth-
ods operating directly on the equilibrium system of equations are infeasible due to
of the Ramsey model. The analyses in this research monograph, however, focus on OLG economies
that are dynamically efficient.
4 GAMS (General Algebraic Modelling System) is a computer language originally developed to
assist economists at the World Bank in the quantitative analysis of economic policy questions
(Meeraus (1983) and Brooke, Kendrick and Meeraus (1988)). Currently, two large-scale solvers
are available through GAMS/MCP : MILES employs a modified Newton algorithm and PATH is
based on a path-following procedure. For details and more references see Rutherford (1995b).
4 1 Introduction
the high dimensionality related to income and household-specific effects. The Se-
quential Recalibration (SR) algorithm is based on the solution of a sequence of non-
linear complementarity problems. A characteristic of many economic models is that
they can be cast as a complementary problem. Rutherford (1995b) and Mathiesen
(1985) have shown that a complementary-based approach is convenient, robust, and
efficient.5
The main idea of the proposed algorithm is to solve a market economy with many
households through the computation of equilibria for a sequence of representative
agent economies. The dimensionality of the numerical problem is significantly re-
duced by an appropriate decomposition of the system of equations that defines the
dynamic general equilibrium of the OLG economy. To achieve this, the OLG econ-
omy is transformed into a lower-dimensional Ramsey growth problem by replacing
the entire system of overlapping generations with a single infinitely lived represen-
tative agent. Apart from this modification, both models are identical. The first step
in each iteration is to compute a vector of general equilibrium prices given the eco-
nomic policy (or shock) under consideration. In a second step, the candidate prices
are used to evaluate the demand functions of the actual overlapping generations
households. This amounts to solving a partial equilibrium relaxation of the original
OLG economy that suppresses all general equilibrium interactions. The final step in
each iteration uses households’ quantity choices to recalibrate, i.e. to choose a set of
preferences for the artificial Ramsey agent such that, given candidate prices, aggre-
gated quantity choices by OLG households are consistent with the equilibrium be-
havior of the representative agent. The SR algorithm finds the equilibrium allocation
of the underlying OLG economy if the sequence of prices and quantities obtained
from the Ramsey growth model and the partial equilibrium relaxation converge to
the true equilibrium prices and quantities.
The decomposition algorithm provides improvements in both efficiency and ro-
bustness as compared with simultaneous solution methods. To demonstrate this
point, a full-blown Auerbach-Kotlikoff OLG model with production activities, cap-
ital accumulation, endogenous labor supply, and a government sector is augmented
by a large number of heterogeneous households. Evaluating the algorithm’s perfor-
mance compared with an “integrated” complementarity-based approach as put for-
ward by Rasmussen and Rutherford (2004), shows that the decomposition algorithm
is able to solve high-dimensional OLG models that are infeasible for simultaneous
solution methods. Overall, the quality of approximation is found to be excellent and
decreases marginally in the degree of intra-cohort heterogeneity.
To characterize limitations of the SR algorithm, local convergence theory for a
simple exchange economy due to Scarf (1960) is developed, and global conditions
for convergence failure are determined by means of numerical analyses. The condi-
tions for local stability of the implied adjustment process reduce to those of a Wal-
rasian price tâtonnement process. Thus, the proposed algorithm belongs to a large
5 The complementarity format embodies weak inequalities and complementary slackness, relevant
features for models that contain bounds on specific variables, e.g. activity levels which cannot
a priori be assumed to operate at positive intensity. Such features are not easily handled with
alternative solution methods.
1.2 Macroeconomic Consequences of Demographic Change: Focus and New Aspects 5
class of algorithms used in computational economics that are robust, efficient, and
yet fail to provide global convergence. In general, however, the appropriateness of
the proposed algorithm depends on the characteristics of the underlying economic
model. A central result is that the algorithm may be inappropriate for applications in
which there are significant income effects. This deficiency is a consequence of the
simplifying nature of the adjustment process which omits both income constraints
and global characteristics of the individual utility functions.
Notwithstanding these limitations, the decomposition algorithm can be beneficial
for a wide range of economic applications. Due to its decomposition strategy, which
operates on the household side of the economy, it is particularly tailored to models
with many heterogenous households. As such, the SR algorithm can be instrumen-
tal in developing (and solving) large-scale OLG models to analyze in considerable
detail both the inter- and intragenerational distributional implications of economic
policy. In general, however, the decomposition method can also be advantageous for
modeling tasks that need to economize on the dimensionality of the numerical prob-
lem. For instance, multi-sectoral and multi-regional OLG models typically involve
a large number of equations and variables that often render simultaneous solution
methods infeasible. By transforming the OLG model into a lower-dimensional Ram-
sey growth problem, and applying the decomposition approach, the SR algorithm
can create sufficient degrees of freedom in the model architecture to accommodate
such complex research designs.
The proposed algorithm also contributes to the growing literature on the inte-
gration of “micro-macro” models that combine the strengths of both computable
general equilibrium and microsimulation models. The SR algorithm does not only
overcome a principal weakness that is characteristic of many approaches in this
strand of literature (see, e.g., Bourguignon, Robilliard and Robinson (2005) and
Bourguignon and Spadaro (2006)), namely to neglect feedback effects from the mi-
cro to the macro level. Applied to the OLG context, it is also the first computational
device to integrate both approaches in a dynamic framework.
Chapter 3 and Chapter 4 are based on the methodology developed in Chapter 2.
The OLG models developed in both chapters exploit the advantages of the decom-
position algorithm to study specific aspects of the macroeconomic implications of
population aging that have received little attention in the literature. Hence, although
each chapter focuses on economic analysis rather than on computational issues, they
both demonstrate the flexibility, scope, and power of the SR algorithm.
1.2 Macroeconomic Consequences of Demographic Change:

Focus and New Aspects
In many industrialized countries populations are aging, and the demographic tran-
sition will prove to be one of the key factors in shaping the development of soci-
eties in the coming decades. This process is driven by falling mortality rates and
a decline in birth rates, which reduces population growth rates and increases the
6 1 Introduction
share of older people in the economy. While an extensive economic literature has
scrutinized many aspects of the possible economic effects of population aging, see
Börsch-Supan (2004) for an overview, this book relates to the strand of literature
that uses the models and techniques pioneered by Auerbach and Kotlikoff (1987).
From a macroeconomic perspective, the most striking consequence is the change
in the relative abundance of factors of production. As the demographic transition
reduces population growth and decreases the share of young people in the economy,
the aggregate labor force is projected to decline. At the same time, a larger share
of older people—who tend to hold a larger amount of financial wealth—increases
the amount of capital in the economy. Both effects imply that capital in an aging
society becomes abundant relative to labor. Another way of thinking about this is to
imagine that in the light of a shrinking labor force the accumulated capital stock does
not depreciate fast enough to maintain a constant equipment of physical capital per
worker. In other words, demographic change is bound to increase the capital-labor
ratio—often referred to as the process of “capital deepening” (Kotlikoff et al., 2001).
Everything else equal, factor prices will change to reflect the varying scarcities of
capital and labor: the capital rental rate is projected to decline, while wage rates are
bound to increase.
While this adjustment mechanism to demographic change is extensively docu-
mented in the literature, and is at the heart of most analyses, the majority of stud-
ies pays special attention to the impact of aging on the viability of social security
systems in closed economies. Important examples in a closed economy are Huang,
Imrohoroglu and Sargent (1997), De Nardi, Imrohoglu and Sargent (1999), Abel
(2003), and Fehr, Halder and Jokisch (2004a), and in an open economy setting At-
tanasio, Kitao and Violante (2006) and Börsch-Supan, Ludwig and Winter (2006).
Although issues related to social security are probably among the most obvious con-
sequences of demographic change, these are by no means the only consequences.
Population aging affects virtually all markets, i.e. goods markets, labor markets and
capital markets.
This book focuses on an analysis of the economic consequences of demographic
change per se and not just the consequences of alternative social security reform sce-
narios. More specifically, it tries to provide both qualitative and quantitative answers
to questions such as the following: What are the aggregate economic consequences
of population aging? How is individual economic behavior affected? How do re-
turns to capital and labor evolve during the demographic transition? How is the sec-
toral composition of output affected? What are the consequences for the intra- and
intergenerational distribution of income, wealth, and welfare? Does demographic
change make households worse-off? As ongoing and projected demographic pro-
cesses are not synchronized across countries or world regions, how is international
trade affected? Is trade liberalization under such demographic circumstances always
beneficial and how are gains from trade are distributed across generations over time
and between different types of households?
1.2.1 Global Demographic Change and International Trade
A salient feature of global demographic change is the fact that the aging of popu-
lations will occur at differing paces and with a differing degree of intensity in the
industrialized countries of the world. Significant aging is already under way in some
economies, for example in Germany, Italy, Japan, while major demographic changes
in the U.S. and China will begin in the second decade of the 21st century, and with
a still longer lag, demographic trends in the developing economies will follow.
While the existing literature consistently identifies the presence of globally un-
synchronized aging patterns as an important driving force of cross-border flows
of capital and labor (see, e.g., Attanasio and Violante (2005), Börsch-Supan et al.
(2006), INGENUE (2001), and Fehr, Jokisch and Kotlikoff (2004b)), it surprisingly
overlooks its implications for international trade in goods. To fill this gap, Chapter 3
develops an augmented version of the canonical Heckscher-Ohlin model to analyze
the economic consequences of trade liberalization in a world that is characterized by
globally unsynchronized aging patterns. Adopting a stylized dynamic two-country
two-sector two-factor model with overlapping generations it shows that unsynchro-
nized demographic patterns emerge as a potential determinant of international trade
flows. The mechanism behind this is simple: since relative factor endowments are
endogenously determined by life cycle saving and labor supply behavior of over-
lapping generations, different extents and timing of demographic processes across
countries imply international differences in relative factor endowments, and hence
induces Heckscher-Ohlin trade patterns.
If demographic differences emerge as a potential determinant of international
trade flows, a natural question arises whether a country or a region can benefit from
diffusing part of its demographic shock by means of liberalizing its trade policy.
Since trade tends to reduce the dispersion in international factor prices, opening up
an economy for trade might mitigate the pressure on factor prices exerted by popu-
lation aging. However, as real wages and interest rates move in opposite directions,
the overall effect on income and welfare of households is ambiguous. Chapter 3
therefore provides a quantitative assessment of the welfare effects from trade liberal-
ization in the presence of globally unsynchronized aging patterns. Given the absence
of any distortion, and given the perfect neoclassical setup of the model that abstracts
from any form of market imperfection, the general result is surprising, standing in
contrast to what would be expected from standard neoclassical trade theory: that
trade liberalization in the presence of globally unsynchronized aging patterns does
not necessarily lead to welfare gains.
In the fast aging country, trade liberalization is only beneficial for older gen-
erations born before and at the beginning of the demographic transition, whereas
future generations stand to incur substantial utility losses. The reason for this is the
evolution of autarky-trade factor price differentials during the demographic transi-
tion. As trade is bound to increase the real return to capital and to decrease the real
wage rate (relative to autarky), older asset-rich households gain while future genera-
tions suffer from losses in labor income. The model also analyzes the distribution of
welfare gains and losses with respect to an intragenerational dimension. In general,
8 1 Introduction
low-skilled and asset-poor households in the fast aging region tend to be relatively
worse off.
Employing Monte-Carlo simulation methods, the results are found to be robust
for a broad range of empirically plausible parameter configurations. It is estimated
that there is a very high probability for households in the fast aging region not to gain
from liberalizing trade. Moreover, trading off gains from trade for older generations
against welfare losses for younger households, it is found that an aggregate welfare
improvement would only materialize in the presence of unrealistically high social
discount rates.
1.2.2 Quantifying the Sectoral and Distributional Effects of

Population Aging in Germany
Chapter 4 takes a more detailed view of the economic adjustment mechanisms to

demographic change within a country. To this end, it develops a large-scale multi-
sectoral OLG model with intra-cohort heterogeneity to quantify the impact of pop-
ulation aging on the sectoral composition of output and the distribution of income,
wealth, and welfare. The model is calibrated for the German economy and features
17 sectors that represent sectoral aggregates of all 71 industries of the German Input-
Output table. To allow for a meaningful analysis of the distributional implications of
demographic change, the household side of the model distinguishes between eight
household types that correspond to eight income classes of the German Income
and Expenditure Survey (“Einkommens- und Verbrauchsstichprobe”). Demographic
projections from the Federal Statistical Office of Germany are taken as the major ex-
ogenous driving force of the model.
The model focuses on two issues that have received little attention in the liter-
ature. The first objective is to quantify the impact of demographic change on the
sectoral composition of output. In the model, sectoral adjustment rests on two key
mechanisms. First, as technological differences across sectors generally imply that
firms operate at different factor intensities, the increase in the aggregate capital-
labor ratio due to population aging is absorbed quite differently across sectors. Sec-
tors that most efficiently employ abundant capital and attract scarce labor will grow
faster than the rest of the economy, while other sectors will contract due to the de-
mographic transition. Second, as the composition of household consumption varies
with age (see Federal Statistical Office of Germany (2003) for empirical evidence
for Germany, and Börsch-Supan (2003) for a discussion) changes in the popula-
tion structure induce a demand-side driven effect that may give rise to sectoral ad-
justments, too. As the analysis departs from the standard macroeconomic single-
commodity world commonly employed in the literature on demographic change, it
is able to incorporate sectoral shifts and relative price changes as important adjust-
ment mechanisms to demographic change.
The second objective of the model is to quantify the distributional and welfare
consequences of the demographic transition in Germany. As labor is expected to
be scarce relative to capital, real wages are bound to increase while real returns
to capital decrease. A priori, it is not clear how this opposite movement of factor
prices is going to affect households’ labor supply and life cycle savings behavior,
and welfare. The quantitative model is used to estimate the welfare effects of the
demographic transition along inter- and intragenerational dimensions, and to assess
how the distribution of labor income and wealth evolves over time.
Over the main projection period from 2003-2050, the demographic transition in
Germany will bring about a 7% decrease in output per capita. This is largely driven
by a significant decrease in aggregate labor supply, about 17% over the same hori-
zon (as the model features a labor-leisure trade-off this number already incorporates
general equilibrium reactions by households), and a substantial decline in invest-
ment rates (by 26% in 2050). Population aging is shown to imply a “capital deepen-
ing” process that is reflected by an increase in the capital-labor ratio of around 2%.
Real factor prices reflect the varying scarcities of factors of production, and the real
capital rental rate (real wage rate) falls (increases) by 0.5% (0.56%) in 2010, and by
about 1.3% (1.29%) in 2050.
The demographic transition is found to induce substantial changes in the sectoral
composition of output. Sectoral change—as measured by a change in the share of
sectoral output in total domestic output—ranges between −8.5% and +6.5% in year
2010 and between −23.5% and +20% in 2050. Expanding sectors are characterized
by higher growth rates of sectoral employment of labor and capital relative to the
economy-wide growth rates of labor and the capital stock. Accounting for structural
changes in life-cycle consumption that are due to age-specific preferences does not
affect the qualitative results of the benchmark model. At the aggregate level, the
quantitative effects are of minor significance. This suggests that the nature of the
economic transition is predominantly shaped by the negative labor supply shock.
At the sectoral level, however, demand-side induced effects stemming from age-
dependent consumer spending are found to be quantitatively important.
In order to evaluate the welfare consequences of the demographic transition the
following thought experiment is conducted: suppose households of different age and
type alive in 2003 live through the economic transition with changing factor prices
induced by the demographic change, how would their welfare change relative to a
situation without a demographic transition ? The answer is that young households
experience substantial welfare gains because they benefit from a future path of in-
creasing wage rates and do not suffer from too large losses of capital income on al-
ready accumulated financial wealth. In contrast, older asset-rich households tend to
gain less or even lose because of declining interest rates. From an intra-generational
perspective, those members of society for whom labor income constitutes a smaller
part of (future) resources, i.e. , households with relatively low labor productivity,
benefit less from the demographic transition.
In Germany, the demographic transition is projected to increase income inequal-
ity. The growing dispersion in household income is driven by a rise in capital income
inequality, and overcompensates the projected decrease in labor income inequality.
Labor income inequality decreases because a future path of increasing wages im-
plies a tendency towards a flatter labor supply profile over the life cycle. It is also
10 1 Introduction
found that intergenerational factors, rather than a redistribution between different

types of households within a particular age group account for the observed evolu-
tion of income inequality.
Finally, Chapter 5 concludes with a discussion of a number of simplifying as-
sumptions that underly the economic analyses in Chapter 3 and Chapter 4. This also
serves to point out possible extensions of the work presented here.
Chapter 2
Computation of Equilibria in OLG Models with
Many Heterogeneous Households
2.1 Introduction
Over the past twenty years infinite horizon general equilibrium models with over-
lapping generations (OLG) have become an important tool for policy analysis, and
have been fruitfully applied in fields such as macroeconomics or public finance (see,
e.g., Auerbach and Kotlikoff (1987), and Kotlikoff (2000) for an overview). OLG
models naturally involve a large number of variables and equations that describe
the equilibrium behavior of economic agents. As a consequence, the development
of large-scale OLG models is often limited by the computational capacity of avail-
able numerical solution methods. In particular, models that exhibit a rich household
side including a variety of household-specific effects, a large number of heteroge-
neous households, and realistic agent lifetimes typically require “customized solu-
tion methods” which may be both costly to implement and difficult to validate.
This chapter1 develops a decomposition algorithm based on “off the shelf nu-
merical tools” for solving general equilibrium models with many households, of
which OLG models are a special case. The presented approach is primarily appro-
priate for computing equilibria for models in which the number of agents is so large
that simultaneous solution methods operating directly on the equilibrium system
of equations are infeasible due to the high dimensionality related to income and
household-specific effects. The “sequential recalibration” (SR) algorithm presented
here is based on the solution of a sequence of nonlinear complementarity problems2
although in special cases the same procedure may be implemented by solving a
1 This chapter has been jointly written with Thomas F. Rutherford. GAMS code for the presented
applications is available at http://www.mpsge.org.

2 Rutherford (1995b) and Mathiesen (1985) have shown that a complementary-based approach
is convenient, robust, and efficient. A characteristic of many economic models is that they can
be cast as a complementary problem, i.e. given a function F : Rn −→ Rn , find z ∈ Rn such that
F(z) ≥ 0, z ≥ 0, and zT F(z) = 0 The complementarity format embodies weak inequalities and
complementary slackness, relevant features for models that contain bounds on specific variables,
e.g. activity levels which cannot a priori be assumed to operate at positive intensity. Such features
are not easily handled with alternative solution methods.

12 2 Computation of Equilibria in OLG Models with Many Heterogeneous Households
sequence of convex nonlinear programming problems. The main idea of the pre-
sented decomposition approach is to solve a market economy with many house-
holds through the computation of equilibria for a sequence of representative agent
economies. Typically, the sequence of prices and quantities converges to the true
equilibrium allocation.
The close connection between the allocation of a competitive market economy
and the optimal solution to a representative agent’s planning problem is well known
and widely cited in the economic literature. Negishi (1960) was the first to use an op-
timization problem to characterize equilibrium allocations in a general equilibrium
framework. Negishi’s original paper was primarily concerned with optimization as a
means of proving existence. Dixon (1975) developed the theory and computational
effectiveness of “joint maximization algorithms” for multi-country trade models.
Rutherford (1999b) presented the “sequential joint maximization algorithm” (SJM)
which provides a simple recursive version of Negishi’s method.
There are similarities between the SR and SJM algorithms. Both approaches
solve subproblems representing relaxations of the equilibrium conditions. The SJM
algorithm ignores consumer budget constraints but retains details of consumer de-
mand systems. The SR algorithm employs a yet looser representation of individual
consumer’s demand systems by omitting both income constraints and global prop-
erties of the individual utility functions. The omission of global characteristics of
preferences simplifies the model but can hinder convergence. The appropriateness
of the proposed solution method therefore depends on the characteristics of the un-
derlying model.
The decomposition approach can be useful for the computation of equilibria in
large-scale general equilibrium models with many households. There are many eco-
nomic questions for which heterogeneous agent models have to be used to provide
answers, and an increasing amount of research employs frameworks that allow for
intra-cohort heterogeneity in an OLG setup.3 We believe that the presented approach
can be beneficial for a wide range of economic applications, in particular within the
class of OLG models, for the following reasons. First, by significantly reducing the
computational overhead of the numerical problem at hand this method facilitates
the development of OLG models which feature a complex and rich household side.
This strengthens the microfoundation of the models in general and allows to an-
alyze in detail intra- and intergenerational distributive consequences of economic
policy. Second, the presented approach enables to solve OLG models that include a
“realistic” number of households within each age group since the number of house-
holds in the model more closely corresponds to the number of observational units
available from household survey data. This approach avoids relying on some ad-
3 For instance, Conesa and Krueger (1999), Kotlikoff et al. (1999), and Huggett and Ventura (1999)
investigate the intra-cohort distributive and welfare consequences of social security reform. Fehr
(2000) looks at pension reform during the demographic transition in the case of Germany. Ventura
(1999) explores the general equilibrium impact and associated distributional consequences of a rev-
enue neutral tax reform, and Jensen and Rutherford (2002) analyze the intra- and intergenerational
welfare effects of fiscal consolidation via debt reduction. This chapter concentrates on applica-
tions within the Auerbach-Kotlikoff OLG framework. For a general discussion of economies with
heterogeneous agents, see, e.g., Rios-Rull (1995).
2.1 Introduction 13
hoc aggregation of household groups, and thereby helps to enhance the empirical
basis of the model. Third, and more generally, the method can also be effectively
applied to OLG models which display a high dimensionality deriving from sources
other than the household side. Potential applications may include multi-sectoral and
multi-country models, or models which incorporate a detailed government sector.
In addition, the present contribution adds to the recent and growing body of re-
search that deals with the integration of macro and microsimulation models, the
“micro-macro” approach to modeling (Bourguignon and Spadaro, 2006). This strand
of literature aims to combine the strengths of both the computable general equilib-
rium (CGE) paradigm and microsimulation models. While CGE models have be-
come standard tools of quantitative policy assessment in the last twenty years, two
major criticisms are their reliance on the concept of the “representative agent” and
their usage of unclear aggregation procedures. The virtue of the microsimulation ap-
proach, on the other hand, is to replace representative agents with “real households”
as observed in standard household surveys. This, however, is typically achieved at
the cost of ignoring general equilibrium effects that are essential for policy analysis.
The simplest link between economy-wide modeling and the microsimulation ap-
proach proceeds top down, i.e. simulated policy changes obtained from an aggregate
representation of the economy are passed down to a microsimulation module, as,
e.g., in Bourguignon et al. (2005) and Bourguignon and Spadaro (2006). The princi-
pal weakness of the top-down approach is the absence of feedback effects from the
micro to the macro level. Relatively few studies have attempted to fully integrate
both approaches, most of them by means of employing an iterative strategy between
the microsimulation and the CGE model (Cockburn and Cororatona (2007), Savard
(2003, 2005), Arntz et al. (2006)). Also belonging to this class of models, Rutherford
and Tarr (2008) applied the SR algorithm to a large-scale, static general equilibrium
model with 25 sectors and 53,000 households to assess the poverty effects of Rus-
sia’s WTO accession. All of these studies, however, are concerned with applications
in a static framework. Clearly, covering complex behavioral responses and potential
general equilibrium and macroeconomic effects in a dynamic setup is essential for
many policy issues.4
The present chapter develops a computational technique that allows to fully inte-
grate a comprehensive system of OLG households, that exhibits a substantial degree
of intra-cohort heterogeneity, into a generic Auerbach-Kotlikoff model. We show
that the positive experience of the SR algorithm for large-scale static models car-
ries over to dynamic applications and demonstrate its effectiveness for solving OLG
models with a large number of heterogeneous households. To find the equilibrium
transition path of the OLG economy, the presented algorithm solves a sequence of
“related” Ramsey optimal growth problems where the system of overlapping gener-
ations is replaced by an infinitely-lived representative agent. An iterative procedure
4 Available models tend to concentrate on some specific behavior, abstracting from other impor-
tant components of the demo-economic life cycle. For instance, Townsend (2002), Townsend and
Ueda (2003) concentrate on saving/investment behavior under uncertainty and in different financial
market environments.
between the macro and micro model is employed based on the successive recalibra-
tion of preferences of this artificial representative agent.
In order to characterize limitations of the algorithm, local convergence theory
for a simple exchange economy due to Scarf (1960) is developed and a number
numerical analyses are carried out to examine global conditions under which the
SR algorithm may fail to converge. We show that conditions for local stability of
the adjustment process reduce to those of a Walrasian price tâtonnement process,
thus SR belongs to a large class of algorithms commonly used in computational
economics which are robust and efficient, yet fail to provide global convergence.
The presented counterexample illustrates that the SR algorithm may be ill-suited for
applications in which there are significant income effects.
After having characterized limitations of the technique, this chapter explores the
algorithm’s performance when applied to large-scale OLG models. To this end, a
prototype Auerbach-Kotlikoff model is considered which includes up to 2000 het-
erogeneous households within each generation differing with respect to labor pro-
ductivity over the life cycle and other behavioral parameters. The performance of
the SR algorithm is compared to a simultaneous solution method as suggested by
Rasmussen and Rutherford (2004). We find that the proposed algorithm can pro-
vide improvements in both efficiency and robustness. It is furthermore demonstrated
that the decomposition algorithm can routinely solve high-dimensional OLG mod-
els which are infeasible for conventional solution methods.
Lastly, it is important to emphasize that the decomposition method is inadequate
for approximating equilibria in OLG economies that are generically Pareto-inferior,
i.e. models in which the economy’s growth rate exceeds the real interest rate (see,
e.g., Diamond (1965) and Phelps (1961)). For the given model, this corresponds to
a situation where population growth dominates discounting. In such circumstances
there is no social planner’s problem which corresponds to the OLG demand system.
Whether this significantly limits the relevance and scope of the presented approach
ultimately is an empirical question. Empirical evidence suggests that the incapacity
of the method to deal with dynamically inefficient equilibria is of minor practical
significance.5
The rest of the chapter is organized as follows. Section 2.3 introduces the SR
algorithm for the case of a static economy and illustrates its basic logic by means
of graphical analysis. Section 2.4 investigates a model where convergence of the SR
algorithm fails if income effects are relatively strong. Section 2.5 demonstrates that
the algorithm can be effectively applied to solve Auerbach-Kotlikoff OLG models.
Furthermore, the performance of the algorithm is compared to computational expe-
rience from an integrated simultaneous solution method. Section 2.6 concludes.
5 Abel et al. (1989) find that for the US economy the condition for dynamic efficiency seems to be
satisfied in practice. Similarly, under the weak assumption that rates of return are ergodic, Barbie,
Hagedorn and Kaul (2004) reach the conclusion that the US economy does not overaccumulate
capital. By means of numerical analysis, Larch (1993) suggests that in the Auerbach-Kotlikoff
framework rather implausible values of the pure rate of time preference, the intertemporal elasticity
of substitution or the population growth rate are required to obtain non Pareto-optimal market
solutions.
2.2 Calibration in CGE models 15
2.2 Calibration in CGE models
In order to facilitate the subsequent description of the algorithm and to clarify the al-
gebraic forms used in the associated computer programs, this section reviews some
fundamental aspects of calibration which underly most computable general equilib-
rium (CGE) models.
2.2.1 CES Preferences
Calibration refers to the process of selecting values of model parameters which en-
sure that the model’s reference equilibrium is consistent with given data. Such data
are typically obtained in the form of a social accounting matrix for a given base
year. CGE models are based on parametric forms which describe technology and
preferences. The most common functional form used in empirical applications is
the constant-elasticity-of-substitution (CES) function. A CES utility function can
be written as: ! 1/ρ
n
ρ
U(C) = ∑ αi Ci (2.1)
i=1
where C denotes the vector of consumption goods Ci , i = 1, . . . , n. There are n + 1

parameters in this function, with n share parameters αi > 0 and a curvature pa-
rameter ρ. The latter is related to the Allen-Uzawa elasticity of substitution σ as:
ρ = 1 − 1/σ with ρ < 1 and σ > 0.
Consumers in CGE models are typically modeled as budget constrained utility-
maximizers, so a model would incorporate the following behavioral subproblem:
maxc1 ,...,cn U(C)

s.t. ∑ni=1 pi Ci = M (2.2)
where pi is the price of consumption good i, and M is consumer income. The con-
sumer problem in closed-form can be solved, obtaining demand functions:
αiσ M p−σi
Ci (p, M) = (2.3)
∑i0 αiσ0 p1−σ
i0
where p denotes the price vector, and i 6= i0 . The calibration of preferences involves
inverting this demand function to express the function parameters in terms of an
observed set of prices and demands. If a consumer chooses to consume quantities
Ci when commodity prices are pi , it may be concluded that the share parameters
have to be given by:
1−ρ
α i = λ pi C i (2.4)
where λ > 0 is an arbitrary scale factor6 , and the elasticity parameter, ρ, is exoge-
nously specified. It is helpful to think of the share and scale parameters as cali-
brated values, determined by an agent’s observed choices in a reference equilibrium,
whereas the elasticity parameters are “free parameters” which are typically drawn
from econometric estimates of the responsiveness of demand or supply to changes
in relative prices. In traditional applied general equilibrium models, the reference
quantities Ci and prices pi are based on a benchmark equilibrium data set.
2.2.2 The Calibrated Share Form
In applied work it may be convenient to work with a different yet equivalent form of
the CES utility function (Rutherford, 1995a). The calibrated share form is based on
the observed quantities, prices and budget shares. In computational applications the
calibrated form is preferable because it provides a simple parameter and functional
check that is independent from second-order curvature. Normalizing the benchmark
utility index to unity, the utility function can be written as:
" ρ #1/ρ
Ci
U(C) = ∑ θi (2.5)
i Ci
in which:
pi Ci
θi = (2.6)
∑i0 pi0 Ci0
is defined as the benchmark value share of good i. Similarly, one can express the
unit expenditure function as:
" 1−σ #1/1−σ
pi
e(p) = ∑ θi , (2.7)
i pi
the indirect utility function as:

M
V (p, M) = , (2.8)
e(p) M
and by Roy’s identity the demand function as:

σ
M e(p) pi
Ci (p, M) = Ci (2.9)
e(p) M pi
where M = ∑i pi Ci .
6 The consumer maximization problem is invariant with respect to positive scaling of U, hence the
share parameters may only be determined up to a scale factor.

2.3 CGE with Many Households: A Decomposition Approach 17
One can think of the demand function given here as a second-order Taylor approx-
imation to the “true” demand function based on an observation of the true function
at the reference point. At that point, Ci corresponds to a “zeroth order approxima-
tion” to the utility function, pi corresponds to the “first order approximation”, and
the “free parameter” σ controls the second (and higher) order properties of prefer-
ences. The benchmark prices correspond to the marginal rate of substitution—the
slope of the indifference curve—at C. As long as one remains in the neighborhood
of p, the elasticity parameter σ only plays a minor role, and calibrated demand is
determined largely by C and p.
2.3 CGE with Many Households: A Decomposition Approach
This section presents the decomposition method by which a market economy with
many heterogeneous households may be solved through the computation for equi-
libria for a sequence of representative agent economies. While the primary interest
is in dynamic models, it is advantageous to introduce the algorithm for the case of
a two-sector static economy in which one can provide a graphical description that
serves to illustrate its basic logic.
2.3.1 A Static Economy
Consider the following static economy which is populated by a large number of

heterogeneous households h = 1, . . . , H each of whom is endowed with K h and Lh
units of capital and labor, respectively. Households earn income M h = rK h + wLh
from supplying their factor endowments inelastically at respective market prices r
and w. Household h = 1, . . . , H solve:
 h
1/ρ h
2 ρ
chi

max U h (ch ) =  ∑ θih 
ch1 ,ch2 i=1 chi
2
s.t. ∑ pi chi = Mh . (2.10)
i=1
where the utility function is written in calibrated share form. θih and chi denote the
benchmark value share and the benchmark consumption of good i for household h.
Households are heterogeneous with respect to θih , ρ h , K h , and Lh .
Furthermore, there is a single representative firm which uses capital and labor
services to produce two consumption goods Xi , i, j = 1, 2, according to a constant
returns to scale production function Xi = fi (K, L), where K = ∑h K h and L = ∑h Lh .
All goods and factor markets are perfectly competitive.
2.3.2 A Decomposition Algorithm
The main challenge for computing equilibria in a setup where H is very large is
dimensionality. Typically, conventional simultaneous solution methods that operate
directly on the equilibrium system of equations are infeasible. The proposed algo-
rithm decomposes the corresponding numerical problem into two parts and thereby
effectively manages to reduce its dimensionality. The general equilibrium of the un-
derlying economic model is approximated by computing equilibria for a sequence
of representative agent economies. In each iteration, first a general equilibrium rep-
resentation of the underlying economic model is solved in which the household side
is replaced by a single representative agent (RA). The second subproblem then con-
sists of solving a partial equilibrium relaxation of the original model that retains
the full structure of the household demand system. Given equilibrium prices from
the previous solution of the RA economy, it is possible to compute optimal choices
for each of the “real” households. In a next step, and to create a basis for succes-
sive iterations, the preferences of the “artificial” RA are recalibrated such that given
candidate equilibrium prices the RA choices replicate aggregate household choices.
The key departure from the routine use of calibration in the decomposition al-
gorithm is the idea that the calibration of preferences occurs more than once. The
first iteration of the algorithm is based on observable benchmark data, but in sub-
sequent iterations the preferences of the RA are sequentially recalibrated to values
determined in the iterative process. For the case of the static economy as described
above, the SR algorithm involves the following steps:
Step 0: Initialize the Representative Agent Economy
In the computation of equilibria we will portray the choices of H households us-

ing a single representative agent. To construct an RA economy of the underlying
economic model, replace (2.10) by:
" !ρ #1/ρ
2
Ci
max U k (C) = ∑ Θik k
C1 ,C2 i=1 Ci
2 H H
s.t. ∑ pi Ci = w ∑ Lh + r ∑ K h (2.11)
i=1 h=1 h=1
where k is an iteration index. Factor endowments of the RA equal the sum of re-
spective factor endowments across all households. To initialize the RA economy at
a consistent data point, the data set has be constructed such that the RA model and
the household model share the same optimal consumption quantities in the initial
benchmark. This is achieved by setting:
X2
A B
P0 P1
X1
Fig. 2.1 Solution to the initial representative agent model (Step 0 and Step 1)
H
0
Ci = ∑ chi (2.12)
h=1
0
pi C i
Θi0 = 0
, i 6= i0 (2.13)
∑i0 pi0 Ci0
0
where Ci and Θi0 denote initial consumption by the RA and the aggregate value
share for good i in iteration k = 0, respectively.
This initial consumption point of the RA in the benchmark equilibrium is rep-
resented by point A in Figure 2.1 where initial goods prices are denoted by P0 .
Benchmark prices and an arbitrary elasticity are used to extrapolate preferences in
the neighborhood of the benchmark point to the global preferences of the RA, as
indicated by the indifference curve which is tangent to the benchmark budget con-
straint at point A. The key limitation of the RA model on the demand side is that
the “community indifference curve” represented by this indifference curve does not
truthfully portray the response of household demand to a comprehensive change in
both goods and factor prices.
Step 1: Solve for a General Equilibrium of the RA Economy
The solution to the RA model in the first iteration of the algorithm is illustrated in
Figure 2.1. As depicted here, the assumed exogenous policy shock has led to an in-
crease in factor earnings, and a reduction in the relative price of X1 as compared with
X2
A B
P0 P1
X1
Fig. 2.2 Evaluating household demands at new prices (Step 2)
X2 . This new price situation is denoted by P1 . The RA model, based on the assumed
community indifference curve and the associated change in factor and commodity
prices returns point B as the optimal consumption point.
Step 2: Evaluate Household Demand Functions
In the solution program equilibrium prices are read from the RA model and evaluate
the household demand vector. This produces a different point on the same budget
constraint (see Figure 2.2). The household demand model is based on compensated
demand functions so the aggregate budget constraint for the household demand sys-
tem is equivalent to the budget constraint which applies to the RA. Point C corre-
sponds to the aggregate demand which results from solving the individual household
optimization problems. The extent to which C differs from B depends on both the
difference in implicit substitution elasticities and differences in income effects.
Step 3: Recalibrate Preferences of the Representative Agent
The next step in the algorithm consists of specifying a new set of preferences for
the RA model. The algorithm is termed “sequential recalibration” on the basis of
this idea. After having solved one RA model, a new RA model is constructed based
on a set of preferences which are locally calibrated to the aggregate consumption
quantities at point C and the associated relative prices. This ensures that given prices
P1 the optimal consumption point of the new RA, point C in Figure 2.3, is consistent
with the aggregated choices by households. Preferences of the RA in iteration k,
X2
A B
P0 P1
X1
Fig. 2.3 Recalibration of preferences (Step 3)
U k (C) in (2.11), are based on household demands at the prices returned in iteration
k − 1:
k
Ci = ∑ chi (pk−1 , Mhk−1 ) (2.14)
h
in which chi (pk−1 ) is the demand for good i by household h evaluated at the candidate
price vector from the previous iteration k − 1, and where factor income of household
h in iteration k, Mhk (pk ), is a function of prices in iteration k. Likewise, value shares
in U k (C) are updated to:
pk−1
i ∑h chi (pk−1 , Mhk−1 )
Θik = (2.15)
∑ j pk−1
j ∑h chj (pk−1 , Mhk−1 )
where θik is the aggregate value share of good i at iteration k − 1. The indifference
curves tangent at A and B are based on identical preferences, but the indifference
curve tangent at point C is based on a new set of community indifference curves,
hence it may intersect the indifference curves based on RA utility in the previous
iteration of the algorithm. Note that the preferences of the “real” households remain
unchanged throughout the entire iteration process.
X2
C
D
A B
PPF PPF' P1 P2
X1
Fig. 2.4 Iterative adjustment
Iterative Adjustment
When the RA model is recalibrated at point C, both the representative agent and
all households are in equilibrium at C with prices P1 , but at these prices firms will
only supply quantities given by point B. Hence, due to inconsistency with the sup-
ply side of the model there is a general disequilibrium. To illustrate this idea, it is
convenient to portray the supply side of the economy by a production possibility
frontier (PPF). Assume that the policy shock produces an expansion in the PPF (to
PPF 0 ) and a substantial change in relative prices from point A to B. The next step
in the solution program is to resolve for a general equilibrium of the new RA model
with recalibrated preferences at point C. Point C in Figure 2.4 becomes therefore
interpreted as point A in the next iteration. The solution of this RA model is then
characterized by a new optimal consumption point, here depicted by point D, and
prices P2 .
Subsequent iterations involve carrying out Steps 1 to Steps 3 (Step 0 initializes
the solution procedure). The process is stopped if some convergence metric, e.g., the
1-norm of the difference between the price vectors from one iteration to the next, is
satisfied. Note that subsequent iterations of the algorithm only involve refinements
of the demand system and result in much smaller changes in relative prices, as indi-
cated here by the change from C to D as compared with A to B.
2.4 Convergence Theory 23
2.4 Convergence Theory
This section evaluates the performance of the algorithm for an economy in which
the exact equilibrium is known and where the computed allocation can be compared
to the true equilibrium allocation. Local convergence theory for the proposed algo-
rithm is developed and conditions under which the adjustment process may fail to
converge are identified.
The example is due to Scarf (1960) who considers a pure exchange economy
with an equal number of n consumers and goods. Consumer h is endowed with one
unit of good h and demands only goods h and h + 1. Let di,h denote demand for
good i by consumer h. Preferences are represented by CES utility functions with the
following structure:
σ σ σσ−1
σ −1 σ −1
Uh (d) = θ dh,h + (1 − θ ) dh+1,h . (2.16)
Scarf (1960) demonstrates that this economy has a unique equilibrium in which all
prices are equal to unity.7
2.4.1 Local Convergence
As explained in Section 2.3.2, the sequential recalibration algorithm iteratively ad-

justs the baseline level parameter Ci (and Θi (Ci )) in the utility function of the repre-
sentative agent. These may be normalized so that ∑i Ci = n. Market clearing com-
modity prices for the RA economy are determined given the baseline level parame-
ters. Let pi (C) denote the price of good i consistent with C = (C1 , . . . ,Cn ). In this ex-
change economy, let ζi p(C) denote the market excess demand function for good
i that is obtained from evaluating household demand functions. Given the special
structure of preferences and endowments, this function has the form:

ζi p(C) = di,i + di,i−1 − 1 . (2.17)

Furthermore, let ξi C denote the value of market excess demand for good i at
prices pi (C):
ξi C = pi (C) ζi p(C) . (2.18)
∗
Of course, in equilibrium it must be true that ξi (C ) = 0, ∀ i. Let the initial es-
0 0
timate C be selected on the n-simplex, i.e. ∑i Ci = n. Walras’ law ensures
that the adjustment process ddCt i = ξi C remains on the n-simplex: d ∑di Ct i (t) =

∑i pi (C(t)) ζi p(C(t)) = 0.
7 See Lemma 1 and Lemma 2 (Scarf, 1960, p.164). The parameters of this utility function corre-
1 b
spond to Scarf’s parameters a and b (Scarf, 1960, p.168) as: σ = 1+a and θ = 1+b .
Local convergence concerns properties of the Jacobian matrix evaluated at the

∗
equilibrium point, ∇ξ (C ) = [ξi j ]. This Jacobian has entries defined as follows:
 ∂ ζi ( p(C))

∂ ξi ∂ Ci
i= j
ξi j ≡ = . (2.19)
∂ C j  ∂ ζi ( p(C)) i 6= j
∂Cj
∗
If all principal minors of ∇ξ (C ) = [ξi j ] are negative, the adjustment process is
∂ ζ ( p(C))
locally convergent. If, however, i∂ C > 0, the process is locally unstable. When
i
an equilibrium is unique and the process is uninterrupted, then local stability implies
global instability.
For this model, the tâtonnement price adjustment process is unstable (in the case
θ 1
n = 3) when 1−θ > 1−2σ (Scarf, 1960). In the following, it is shown that the same
condition implies instability for the C-adjustment process of the SR algorithm. Fur-
thermore, it is shown (numerically) that while the tâtonnement and SR price adjust-
ment processes are locally identical, they may be quite different at points in the price
space that are sufficiently far away from the equilibrium.
Given the special structure of ζi p(C) , one can write:
∂ ζi ∂ di,i ∂ di,i−1 ∂ ζi ∂ di,i−1 ∂ ζi ∂ di,i

= + , = , = . (2.20)
∂ pi ∂ pi ∂ pi ∂ pi−1 ∂ pi−1 ∂ pi+1 ∂ pi+1
Defining the “unit-utility” expenditure function for consumer i as:
1
ei (p) = θ p1−σ + (1 − θ ) p1−σ
1−σ
i i+1 (2.21)
demand functions are given by:
θ pi (1 − θ ) pi
di,i = 1−σ σ
, di+1,i = . (2.22)
ei pi e1−σ
i pσi+1
∂ ζi ( p(C))
Evaluating ∂ Ci
at p∗ = 1, yields

∂ ζi p(C) ∂ pi
(2σ − 2)θ 2 + (3 − 2σ )θ − 1

=
∂ Ci ∂ Ci
∂ pi+1
+ (−θ (1 − θ )(1 − σ ))
∂ Ci
∂ pi−1
+ (−θ (1 − θ )(1 − σ ) + 1 − θ ) . (2.23)
∂ Ci
The function p(C) is defined implicitly by the equation:

ζe p,C = 0 (2.24)

where ζe p,C denotes the vector of market excess demand functions from the rep-
resentative agent economy. Its i-th element is given by:
Ci
ζei p,C = −1 (2.25)
∑i0 αi0 p1−
i0
σe
pσie
Ci
with αi0 = and where σe denotes the elasticity of substitution for the repre-
∑ i0 C i0
∗
sentative agent. In order to evaluate ∇ p ζe at C , we make a first-order Taylor series
expansion:

∇ p ζe p,C d p + ∇C ζe p,C d C = 0 (2.26)
which gives:
dp
= −∇−1
p ζ ∇C ζ .
e e (2.27)
dC
∗
Evaluating gradients at p∗ = C = 1 yields:
 −(2σe +1) −(1−σe ) −(1−σ e)

3 3 3
−(1−σe ) −(2σ
e +1) −(1−σ e)
∇ p ζe =  (2.28)
 
3 3 3 
−(1−σe ) −(1−σ e ) −(2σ
e +1)
3 3 3
 
e −1 σ
e +2 σ
σ e −1
3σ
e 3σ
e 3σ
e
−∇−1
p ζ =
e  e −1 σ
σ e −1
e +2 σ
(2.29)

3σ
e 3σ
e 3σ
e 
e −1 σ
σ e −1 σ
e +2
3σ
e 3σ
e 3σ
e
 
100
∇C ζe =  0 1 0  . (2.30)
001
Hence, in the neighborhood of the equilibrium:
∂ pi (C) σe + 2 ∂ pi (C)
= > 0, = 0. (2.31)
∂ Ci 3σe ∂ Cj
From (2.23) it therefore follows that the adjustment process in C is locally unstable
if:
(2σ − 2)θ 2 + (3 − 2σ )θ − 1 > 0 (2.32)
which is equivalent to the condition for instability of a simple price tâtonnement
adjustment process as demonstrated by Scarf (1960, p.169).
p3
p1 p2
Fig. 2.5 Comparison of SR and tâtonnement fields
2.4.2 Global Convergence
Although the local behavior of the price tâtonnement and the SR algorithm adjust-
ment processes are identical, they produce different search directions away from
a neighborhood of the equilibrium. This is apparent in Figure 2.5 where the two
vector fields are superimposed. Only local to the equilibrium where price effects
dominate income effects, do the two fields coincide exactly, as indicated by (2.32).
As one moves further away from the center of the simplex, the vector fields become
more divergent. It is found that there are cases in which the SR algorithm does not
converge even though the price tâtonnement is globally stable. This convergence
failure is a manifestation of the simplifying nature of the adjustment process. By
solving a sequence of representative agent economies the SR algorithm omits both
income constraints and global properties of the individual utility functions. While
the omission of global characteristics of preferences reduces the dimensionality of
the model significantly, this may at the same time hinder convergence.
16
2.00 12
8
1.75
4
1.50 non-convergent
1.25
s 1.00
0.75
0.50
0.25
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Fig. 2.6 Global convergence behavior for different configurations of θ and σ
To assess the global convergence properties of the SR algorithm, a grid search

over the behavioral parameters σ and θ is performed. We let the algorithm start from
a disequilibrium point p = (0.2, 0.2, 0.6) where local equilibrium dynamics are ab-
sent. Figure 2.6 reveals that convergence of the SR algorithm fails for combinations
of small values for σ and high values for θ .8 For these parameter configurations,
income effects are relatively strong vis-à-vis substitution effects. In cases where
convergence is achieved, the presence of significant income effects means that more
iterations are required to find the true equilibrium. If, however, income effects are
relatively weak, the SR algorithm only requires a modest number of iterations. The
appropriateness of the presented solution method therefore depends on the charac-
teristics of the underlying model.
One last remark is in order. To guarantee convergence of the SR algorithm, it is
necessary to select a sufficiently large value for σe , the elasticity of substitution of the
representative agent. If σe is too low, convergence may fail even if income effects are
relatively weak. Non-convergent behavior, however, that occurs in the bottom right
corner of Figure 2.6 is robust with respect to σe . The choice of σe is entirely innocu-
ous since this parameter bears no economic significance for the behavior of “real”
households in the underlying economic model. Computational experience suggests
to use values of order σe ≥ 1.
8 For both parameters, a grid resolution of 0.05 is chosen, σe is set to one, and a maximum of 1000
iterations is allowed for. The adjustment process is said to converge if the 1-norm of differences
between a computed price vector and the equilibrium point drops below some metric δ , i.e. kpi −
p∗i k1 < δ , where p∗i denotes the analytical equilibrium solution. We set δ = 0.01.
2.5 OLG Models with Many Households
This section presents a decomposition algorithm for solving overlapping generations

models with many heterogeneous households. The proposed algorithm is an applica-
tion of the SR approach with a few elaborations specific to the OLG context. As in
the static setting, an equilibrium allocation is approximated by computing equilibria
for a sequence of representative agent economies. In the case of OLG, the represen-
tative agent economies are Ramsey optimal growth problems where the system of
overlapping generations is replaced by a single infinitely-lived agent.
The algorithm is demonstrated for a simple prototype Auerbach-Kotlikoff OLG
economy with production activities, intra-cohort heterogeneity, a labor-leisure choice,
and a government sector.9 We solve for the effects of a tax reform that is intro-
duced unexpectedly in year zero, and then evaluate the performance of the algorithm
against numerical solutions that are available from simultaneous solution methods.
2.5.1 A Prototype Auerbach-Kotlikoff OLG Model
2.5.1.1 Households
Time is discrete and extends from t = 0, . . . , ∞. There is no aggregate or household-

specific uncertainty. The economy is populated by overlapping generations of het-
erogeneous agents. A household of generation g and type h = 1, . . . , H is born at the
beginning of year t = g, lives for N +1 years, and is endowed with ωg,h,t = ω (1+γ)g
units of time in each period g ≤ t ≤ g + N, and πg,h,t is an index of labor produc-
tivity over the life cycle.10 γ denotes the exogenous steady-state growth rate of the
economy. Leisure time, `g,h,t , enters in a CES function with consumption, cg,h,t , to
create full consumption, zg,h,t . Expressed with present value prices, the optimization
problem is:
9 The example is an adapted version of the production model presented in Rasmussen and Ruther-
ford (2004). A closed economy version of their model with intra-cohort heterogeneity is considered.
While a single-sector model is investigated here, the logic can be readily extended to a multisectoral
framework.
10 ω is a constant income scaling factor which is determined in the initial calibration procedure to
reconcile household behavior with the aggregate benchmark data. For more details see Rasmussen
and Rutherford (2004).
2.5 OLG Models with Many Households 29
g+N t−g 1−1/σh

1 zg,h,t
max ug,h zg,h,t = ∑
cg,h,t , `g,h,t t=g 1+ρ 1 − 1/σh
1
ν
s.t. zg,h,t = αcνg,h,t + (1 − α) `νg,h,t
pc,t cg,h,t + py,t ig,h,t ≤ pl,t πg,h,t (ωg,h,t − `g,h,t ) + pr,t kg,h,t + py,t ζg,h,t
kg,h,t+1 ≤ (1 − δ ) kg,h,t + ig,h,t
`g,h,t ≤ ωg,h,t
cg,h,t , `g,h,t ≥0
kg,h,g ≤ kg,h,g , ig,h,t+N + (1 − δ ) kg,h,t+N ≥ 0 , (2.33)
where ρ is the utility discount factor, σh is the intertemporal elasticity of substitution

for household h, σν = 1/(1 − ν) is the uniform elasticity of substitution between
consumption and leisure, α is a share parameter, and px,t , x = {y, c, l, r}, denotes
the price for the single output good, the price for consumption, the wage rate, and
the capital rental rate, respectively. All prices refer to after-tax prices. Heterogeneity
relates to intra-cohort differences in labor productivity and the intertemporal elas-
ticity of substitution. Households have access to a storage technology: they can use
one unit of the output good to obtain one unit of the capital good next period. We
denote the investment into this technology by ig,h,t . We do not restrict ig,h,t , because
we want to permit households to borrow against future labor income. Private cap-
ital kg,h,t depreciates at an annual rate of δ . kg,h,g denotes the capital holdings of
generation g at the beginning of life t = g. Initial old generations, i.e. generations
born prior to period zero, are endowed with a non-zero amount of assets: kg,h,0 6= 0,
∀ g = −N, . . . , −1, ∀ h. The initial asset distribution for these generations is selected
such that the economy is on a balanced growth path. We assume that newborn house-
holds enter with zero assets: kg,h,g = 0, ∀ g ≥ 0, ∀ h. We furthermore rule out that
households die in debt. In each period of the life cycle households receive ζg,h,t units
of the output good as a lump-sum transfer from the government. For simplicity, we
assume that these transfers are allocated to each generation and type according to its
share in the total population. We moreover assume that the government has no out-
standing debt in the initial steady state and hence households’ total assets in period
zero are equal to the value of the capital stock, i.e. ∑0g=−N ∑H h=1 kg,h,t = (1 + r) K0 ,
where r is the steady state interest rate and K0 is the initial aggregate capital stock.11
2.5.1.2 Firms
There is a single representative firm which in each period t uses capital and labor
services to produce a single output good Yt according to a linearly homogeneous
11 We therefore implicitly assume that the government has no outstanding debt at period zero. A
situation with non-zero initial government debt slightly complicates the calibration procedure but
is conceptually straightforward (see Rasmussen and Rutherford (2004)).
production function Yt = F(Kt , Lt ). All goods and factor markets are perfectly com-
petitive.
2.5.1.3 Government
The government agent collects revenue from levying taxes on consumption, and
on capital and labor income. Tax revenue is spent on government expenditure (Gt )
and on total transfers to households (Tt = ∑tg=t−N ∑H h=1 ζg,h,t ). We assume that the
consumption tax rate (τtc ) adjusts such that the government budget is balanced on a
period-by-period basis:
τtr pr,t Rt + τtl pl,t Lt + τtc py,t Ct = py,t Gt + py,t Tt (2.34)
where τtr and τrl are the net tax rates on capital and labor income, respectively.
2.5.1.4 Aggregate Economy Restrictions
Given inter- and intragenerational heterogeneity, the following feasibility conditions

must be satisfied:
t H
Lt = ∑ ∑ ωg,h,t − `g,h,t (2.35)
g=t−N h=1
t H
It = ∑ ∑ ig,h,t (2.36)
g=t−N h=1
t H
Kt = ∑ ∑ kg,h,t (2.37)
g=t−N h=1
t H
Ct = ∑ ∑ cg,h,t . (2.38)
g=t−N h=1
The law of motion for the aggregate capital stock is given by:
Kt+1 = (1 − δ )Kt + It . (2.39)
Finally, the single output good may be used for household consumption, investment,
or government consumption implying the following condition for balance between
aggregate supply and demand:
F(Kt , Lt ) = Ct + It + Gt . (2.40)
General equilibrium prices
Partial equilibrium relaxation of

Ramsey growth problem of the
the underlying OLG model

underlying OLG model
Step 1: Step 2:
Solve related Ramsey Evaluate household
growth problem demand functions
Step 3:
Recalibrate preferences
of the Ramsey agent Partial equilibrium
quantity choices
Fig. 2.7 Solving OLG by Ramsey: steps in the decomposition algorithm
2.5.2 A Decomposition Algorithm for OLG Models
The unknown equilibrium allocation of the OLG economy described by (2.33)-

(2.40) is approximated by computing equilibria for a sequence of “related” Ram-
sey (optimal) growth problems. Figure 2.7 provides a schematic exposition of the
steps involved in the decomposition procedure. Each iteration comprises the follow-
ing three steps. In the first step, we solve the general equilibrium of the “related”
Ramsey growth problem (Section 2.5.2.1) which retains the full structure of the pro-
duction side of the model but replaces the system of OLG households by a represen-
tative infinitely-lived consumer agent. The second step computes optimal household
behavior given the equilibrium prices from the Ramsey economy (Section 2.5.2.3).
This step can be viewed as solving a partial equilibrium relaxation of the underly-
ing economy that ignores general equilibrium interactions with the production side
of the model but retains the full structure of the OLG demand system. In the third
step, we construct a new Ramsey optimal growth problem by recalibrating the pref-
erences of the “artificial” Ramsey agent based on households’ choices from Step
2 (Section 2.5.2.4). Subsequent iterations proceed with analogous steps. Typically,
the sequence of prices and quantities computed by the algorithm converges to the
true equilibrium allocation. In what follows, we provide more details on each of the
involved steps.
2.5.2.1 The “Related” Ramsey Growth Problem
As the “related” Ramsey optimal growth problem, we define a model of the under-
lying OLG economy in which the system of overlapping generations is replaced by
a single infinitely-lived representative agent, henceforth called the Ramsey agent.

Apart from this modification, the entire economic structure of the OLG model in-
cluding the behavior of other agents, market structure, the number of sectors etc. is
unchanged. The Ramsey agent solves the following optimization problem:
 !1−1/σb  σbσ−1
b
T
Zt
max U (Zt ) =  ∑ Θtk k

Ct , Lt t=0 Zt
!ν !ν ! ν1
Ct Lt
s.t. Zt = ∆tk k
+ 1 − ∆tk k
Ct Lt
Ct + It + Gt = F(Kt , Ωtk − Lt )
Kt+1 ≤ (1 − δ ) Kt + It
Lt ≤ Ωtk
Ct , Lt ≥0
K0 ≤Ψ
KT +1 = K̂T +1 (2.41)
where Ct , Lt , Zt , Kt , It , and Ωtk now denote consumption, leisure time, full consump-
tion, the capital stock, investment, and the time endowment by the Ramsey agent,
respectively, and where σb is the intertemporal elasticity of substitution. k denotes
an iteration index.12
The initial capital stock in the Ramsey economy is given by the aggregate capital
stock of the OLG economy in year zero:
0 H
Ψ= ∑ ∑ kg,h,0 . (2.42)
g=−N h=1
To approximate the infinite-horizon Ramsey economy by a finite-dimensional

complementarity problem, we use the state-variable targetting method suggested by
Lau, Pahlke and Rutherford (2002) in which the target post-terminal capital stock
(K̂T +1 ) is chosen at a level such that investments grow at the steady-state rate in the
last period:
IT
= 1+γ . (2.43)
IT −1
12 Note that the nested lifetime utility function U(Zt ) is written in calibrated share form. We mono-
tonically transform preferences in (2.33) to obtain a linear homogenous CES representation. This
does not alter the underlying preference orderings and hence optimization yields the same demand
functions.
2.5.2.2 Initialization
In order to initialize the “related” Ramsey growth problem, it is first necessary to

characterize a baseline reference path of the OLG economy. For simplicity, we as-
sume that the economy is initially on a balanced growth path and employ a steady-
state calibration procedure proposed by Rasmussen and Rutherford (2004) which
proceeds in two steps. In the first step, the optimal profile of decision variables for
a reference generation of type h is computed subject to given aggregate benchmark
data in year zero. The second step involves extrapolating the results from the house-
hold calibration model, together with remaining elements in the aggregate dataset,
to set up a baseline reference path.
Given this reference path, we choose an initial set of preferences for the rep-
resentative agent such that the Ramsey growth problem endogenously reproduces
the baseline reference path of the underlying OLG economy. This is accomplished
by selecting appropriate reference levels and value share parameters for U(Zt ) in
(2.41):
t H
0
Ct = ∑ ∑ cg,h,t (2.44)
g=t−N h=1
t H
0
Lt = ∑ ∑ `g,h,t (2.45)
g=t−N h=1
0 0 0
Z t = Ct + L t (2.46)
0
pt Ct
∆t0 = 0 0
(2.47)
pt Ct + pt L t
0
pt Z t
Θt0 = 0
(2.48)
∑t 0 pt 0 Z t 0
where pt , t = 0, . . . , T and xg,h,t , x = {c, `}, denote benchmark prices and household
quantity choices, respectively. The superscript “0” indicates starting values.
The Ramsey agent is endowed with units of “productive” time, Ωt , that reflect
households’ labor productivity in a given period:
t H
Ωt0 = ∑ ∑ πg,h,t (ωg,h,t − `g,h,t ) + `g,h,t (2.49)
g=t−N h=1
where `g,h,t is benchmark leisure time by households.

The algorithm is started off by solving the initial Ramsey growth problem as
defined by (2.34), and (2.41)-(2.49). If no policy change is implemented, the given
specification of the Ramsey economy ensures that it can reproduce the initial steady
state path of the underlying OLG economy as an equilibrium solution.
numerical model horizon
Ramsey
0 T
OLG
0 T– N+1 T T+N
terminal post-terminal
generations periods
Fig. 2.8 Approximating OLG by Ramsey: the issue of terminal generations
2.5.2.3 The Partial Equilibrium Relaxation
The second step of the algorithm solves a partial equilibrium relaxation of the un-
derlying OLG economy which retains full details of the household demand system
but ignores general equilibrium effects. Hence, any interactions via commodity and
factor markets and with the production side of the economy are suppressed. Given
equilibrium prices from the previous solution of the “related” Ramsey growth prob-
lem, we evaluate demand functions for each generation and type that originate from
the set of household problems in (2.33).
In order to obtain a good approximation of the underlying OLG economy, it
is necessary to compute optimal household demand for all households and types
in each period of the numerical model that runs from t = 0, . . . , T . This infor-
mation then forms the basis for the recalibration of preferences of the Ramsey
agent in the subsequent step of the algorithm. A complication arises for periods
T − N + 1 ≤ t ≤ T in which generations are born that live beyond T (henceforth
called terminal generations). Figure2.8 illustrates this issue. To compute the optimal
decision profiles of these agents, it is essential to account for their behavior over the
full life cycle. With the last cohort of households being born in period T , this means
that there are N post-terminal periods that have to be included in the analysis, which
we denote by tˆ = T, . . . , T + N. We resolve this issue by employing a steady-state
closure rule which postulates that the economy has reached a steady state by pe-
riod T − N + 1. This additional restriction is not binding if T is chosen sufficiently
large.13 Exploiting this fact, prices for post-terminal periods can be inferred from
the following steady-state projection:
13 The specific choice of T depends on the nature of the policy shock that is considered. In the
numerical examples below we set T = 150.

xTk
xtkˆ = (2.50)
(1 + r∞ )tˆ−T
where xtkˆ = {ptg,h,

k , pt k , pt k } denote the post-terminal price for full consumption,
tˆ y,tˆ l,tˆ
the output good, and the market wage all obtained in iteration k, respectively. Cor-
respondingly, xTk refer to respective prices in the terminal period. The price for full
consumption can be obtained as:

pkg,h,t = eg,h,t pkc,t , pkl,t (2.51)
where eg,h,t (·) denotes the unit expenditure function for zg,h,t . For future reference,
let pg,h,t denote respective benchmark prices. In (2.50), r∞ = pcT −1 /pcT − 1 defines
the endogenous (steady-state) interest rate in the terminal period.
Finally, the lifetime income of generation g and type h, evaluated at candidate
prices from iteration k, is given by:
g+N
k
Mg,h = ∑ πg,h,t pkl,t ωg,h,t + pky,t ζg,h,t + pkr,0 kg,h,g . (2.52)
t=g
A similar formula applies to the lifetime income of terminal generations where for
post-terminal periods projected prices according to (2.50) are used. For future refer-
ence, let M g,h denote the lifetime income at benchmark prices.
We are now in a position to compute household demand. In order to reduce com-
putational complexity, we solve the dual problem making use of formulas (2.7)-(2.9)
(see the Appendix). Let eg,h (pkg,h ) denote the expenditure function for a unit of ug,h
which—given the specific structure of preferences14 —can be constructed using the
vector of prices for the full consumption good, pkg,h (including projected prices).
Indirect utility can then be written as:
k
Mg,h
Vg,h (pkg,h , Mg,h
k
)= ∀g, ∀h. (2.53)
eg,h (pkg,h ) M g,h
Applying Roy’s identity, optimal household demand (in the context of the partial
equilibrium relaxation) for full consumption, goods consumption and leisure, re-
spectively, evaluated at the candidate price vector pkg,h , are updated in each iteration
according to:
14 Note that in the given case of homothetic preferences, the unit expenditure function conveys all
information concerning the underlying preferences.
!σh
eg,h (pkg,h ) pg,h,t
zg,h,t (pkg,h , Mg,h
k
) = zg,h,t Vg,h (pkg,h , Mg,h
k
) (2.54)
pkg,h,t
!σν
pkg,h,t pt
cg,h,t (pkg,h , Mg,h
k
) = cg,h,t zg,h,t (pkg,h , Mg,h
k
) (2.55)
pkc,t pg,h,t
!σν
pkg,h,t pt
`g,h,t (pkg,h , Mg,h
k
) = `g,h,t zg,h,t (pkg,h , Mg,h
k
) . (2.56)
pkl,t πg,h,t pg,h,t
2.5.2.4 Recalibration of the Ramsey Agent’s Preferences
The last step in each iteration is to construct a new Ramsey optimal growth problem
by recalibrating the Ramsey agent’s preferences based on optimal household choices
from the previous step. This is accomplished by updating level parameters in (2.41)
according to:
t H
k+1
Ct = ∑ ∑ cg,h,t (pkg,h , Mg,h
k
) (2.57)
g=t−N h=1
t H
k+1
Lt = ∑ ∑ `g,h,t (pkg,h , Mg,h
k
) (2.58)
g=t−N h=1
k k k
Z t = Ct + L t (2.59)
and value share parameters in (2.41) according to:

k
pkc,t Ct
∆tk+1 = k k
(2.60)
pkc,t Ct + pkl,t L t
k k
pkc,t Ct + pkl,t L t
Θtk+1
=
k k
. (2.61)
∑t 0 pkc,t 0 Ct 0 + pkl,t 0 L t 0
With varying prices, households adjust their labor supply, and hence the compo-
sition of the labor force with respect to age and household type is altered. But since
labor productivity depends on these two socio-economic characteristics, aggregate
labor productivity in the underlying OLG economy also changes. We therefore ad-
just the time endowment of the Ramsey agent in each iteration according to:
t H
Ωtk+1 = ∑ ∑ πg,h,t (ωg,h,t − `g,h,t (pkg,h , Mg,h
k
)) + `g,h,t (pkg,h , Mg,h
k
). (2.62)
g=t−N h=1
Thus, the newly constructed Ramsey optimal growth problem in iteration k + 1 con-
sists of solving (2.41) (subject to (2.42) and (2.43) with updated preference parame-
ters and time endowment as defined by (2.57)–(2.62). This completes the description
of the algorithm.
2.5.3 Algorithmic Performance
The OLG economy presented above has no analytical solution. In order to evaluate
the algorithm, we therefore compare its performance to those of conventional simul-
taneous/direct solution methods. As a benchmark, we take a complementarity-based
approach as suggested by Rasmussen and Rutherford (2004).
The base case parametrization of the economy is as follows. Households live for
51 years or N = 50. We set r̄ = 0.05, γ = 0.01, δ = 0.07, νh = 0.8, β = 0.32, and α =
0.8. In the numerical analysis, we test the performance of the algorithm for a differ-
ent number of household types H and also allow for various degrees of intra-cohort
heterogeneity. For simplicity, we assume that σh , h = 1, . . . , H, are generated by ran-
dom draws from a uniform distribution defined over [σ , σ ]. Likewise, differences in
labor productivity are generated by randomly drawing ag,h from a uniform distribu-
tion with support a ≤ ag,h ≤ a, where the parameter
h ag,h enters the labor productiv- i
ity profile over the life cycle as: πg,h,t = exp 4.47 + ag,h (t − g) − 0.00067 (t − g)2 .
Furthermore, it is assumed that each type has equal size in the total population. The
values for the aggregate data including tax payments in the initial benchmark are
based on Input-Output tables for the U.S. economy in 1996 and are presented at the
top of the corresponding computer programs. We solve the model for T = 150 years.
2.5.3.1 Solving For a Policy Shock: A Fundamental Tax Reform
We now present an illustrative application of the decomposition algorithm by solv-

ing for the effects of a policy change that in year zero unexpectedly and permanently
reduces the capital income tax and introduces a consumption tax to endogenously
balance the government budget. The capital income tax is reduced from a bench-
mark value of 28.4% to 22.9%.
We start out by considering a case where H = 1, σh = 1.2, and ag,h = 0.04. Figure
2.9 shows the sequence of time paths for investment that emerges from the iterative
procedure of the algorithm. The true transition path to a new steady state of the
OLG economy as computed by the benchmark simultaneous solution method is la-
beled “OLG”. “Iteration 1” plots the impact of the tax reform scenario after the first
iteration of the solution method. This is equivalent to what would be obtained from
solving a Ramsey optimal growth model. Each subsequent iteration of the algorithm
produces a new time path for investment that eventually converges to the true solu-
tion. We terminate the search process if kpkc,t − p∗c,t k1 < 10−6 . For the current model,
this is achieved after 34 iterations. Figure 3.7 shows a similar picture for the welfare
Iteration 1 (= Ramsey)
Deviation from steady state (in %)
7.5
Iteration 2
Iteration 3
4
5
7
6
7
...
6.5
OLG = Iteration 34
6
0 20 40 60 80 100 120 140
Time period
Fig. 2.9 Solving OLG by Ramsey: sequence of investment time paths
change experienced by each generation.15 Note that in terms of welfare changes,

stopping after the first iteration corresponds to a situation which would results from
a pure top-down approach that fails to take into account general equilibrium feed-
back effects from the micro to the macro level.
To assess the quality of the approximation, we use the following two measures.
First, the approximation error ek reports the 1-norm of differences between com-
puted consumption prices and true equilibrium prices as calculated by the bench-
mark method: ek = kpkc,t − p∗c,t k1 . As ek constitutes a summary statistic which is
defined over the entire model horizon, it says little about whether price deviations
of the computed from the true price path lie within a tolerable bandwidth. As a sec-
ond measure, we therefore report the maximum distance error τ k which is defined
as: τ k = max{|pkc,t − p∗c,t |}.
Figure 2.11 plots ek as a function of the number of iterations. The approximation
error quickly decreases and then converges to zero. After the first few iterations
the decomposition technique only involves refinements of the demand system, and
consequently, subsequent changes in relative prices are small.
15 Kehoe and Levine (1985) have shown that the OLG framework may permit multiple equilibria
for certain parameter values. In such cases, indeterminacy would manifest itself as sensitivity to the
truncation date. None of the models presented here are sensitive to T, provided that it is sufficiently
large. This and the general robustness of the models provide evidence that the equilibria are unique.
Kotlikoff (2000) reaches the same conclusion regarding the uniqueness of equilibria in the OLG
models he has been working with.
Change in Hicksian equivalent variation (in %) 1.5
Iteration 1
1 Iteration 2
OLG = Iteration 34
0.5
-0.5
-40 -20 0 20 40 60 80 100 120 140
Generation
Fig. 2.10 Solving OLG by Ramsey: sequence of welfare changes by generation
2.5.3.2 Robustness and Accuracy
In order to explore the capacity of the algorithm to solve large-scale OLG models,
we examine its performance for a different number of households and various de-
grees of intra-cohort heterogeneity. We look again at the effects of the tax reform
scenario as described above. Given the simple specification for the source of intra-
cohort differences, we vary the extent of heterogeneity, denoted by Γ , by changing
the support for the distributions from which σh and ag,h are drawn.16
Table 2.1 reports results from a series of runs where the number of households
within each generation is increased while holding fixed the degree of intra-cohort
heterogeneity. The quality of approximation is excellent (τk is around 10−4 ). As
the number of household types increases, the proposed decomposition procedure be-
come advantageous.17 Most importantly, it is shown that the algorithm can provide
improvements in robustness as compared to the benchmark simultaneous solution
method which quickly becomes infeasible for models in which H ≥ 100.
To examine the performance of the algorithm in the presence of a substantial
degree of heterogeneity among households, we report results for different configura-
16 We consider the following sets of choices for {(σ , σ ), (a, a)} ordered by their implied
degree of heterogeneity: Γ1 = {(1.00, 1.50), (0.2, 0.3)}, Γ2 = {(1.00, 1.50), (0.2, 0.4)}, Γ3 =
{(0.25, 0.75), (0.2, 0.3)}, Γ4 = {(0.25, 0.75), (0.2, 0.4)}, Γ5 = {(0.25, 1.25), (0.2, 0.3)}, Γ6 =
{(0.25, 1.25), (0.2, 0.4)}, Γ7 = {(0.25, 2.00), (0.2, 0.3)}, Γ8 = {(0.25, 2.00), (0.2, 0.4)}.
17 All reported running times refer to an implementation on a Dual Core 2 GHz processor machine.
0.015
0.012
1-norm of price changes
0.009
0.006
0.003
0
1 5 10 15 20 25 30
Iteration
Fig. 2.11 Solving OLG by Ramsey: approximation error ek
tions of Γ . We set H = 50 so that the benchmark solution method is feasible and the
calculation of approximation errors is available. Not surprisingly, the approximation
quality of the method is decreasing with the degree of heterogeneity. Overall, the
quality of approximation is still very good: computed prices fall within a reasonably
small interval around the true equilibrium price path (τ k is around 10−5 − 10−3 ).
Motivated by the discussion of the potential convergence failure of the SR al-
gorithm in the presence of significant income effects (Section 2.4), we conduct a
number of sensitivity analyses for behavioral parameters governing intra-period and
intertemporal substitution and income effects (see Table 2.3). Looking first at the
intra-period dimension, we find that combinations of too small ν and α can pose
serious problems for the decomposition approach. Although the search process is
terminated within a modest number of iterations, both approximation measures in-
dicate a rather poor quality of approximation for α ≤ 0.5. If α is too small, the
equilibrium behavior over the life cycle of a household displays periods with zero
labor supply in old ages, i.e. there is endogenous retirement. This happens because
the shadow price of time exceeds the market wage rate. In the presence of such
corner solutions, it is harder to portray the choices of OLG households by using a
representative agent which in turn explains why the approximation error increases.
As for the role of intertemporal income effects, we do not experience problems
of convergence or a poor quality of approximation (results not shown). However,
the speed of convergence (in terms of the number of iterations required for con-
vergence) is the slower, the larger is σh . This finding indicates that income effects
2.6 Concluding Remarks 41
Table 2.1 Convergence performance and approximation error
H Number of iterations Approx. error ek Max. distance τ k CPU computing

(Γ = Γ1 ) (last iteration) (last iteration) time
1 37 10−6 10−7 0 min 13 s (3.78)
10 36 0.002 10−4 0 min 21 s (1.17)
50 35 0.005 10−4 1 min 10 s (0.18)
100 35 — — 2 min 06 s ( × )
500 34 — — 6 min 14 s ( × )
1000 34 — — 10 min 48 s ( × )
2000 29 — — 30 min 31 s ( × )
Note: Figures in parentheses denote running time of the decomposition algorithm expressed as a
fraction of the running time as required by the benchmark simultaneous solution method. A “×”
indicates infeasibility of the simultaneous solution method.
Table 2.2 Approximation errors for different Γ
Γ Number of iterations Approx. error ek Max. distance τ k CPU computing

(H = 50) (last iteration) (last iteration) time
Γ1 35 0.005 10−4 1 min 10 s (0.18)
Γ2 35 0.005 10−4 0 min 56 s (1.14)
Γ3 79 0.001 10−5 2 min 14 s (0.39)
Γ4 74 0.004 10−4 2 min 23 s (0.42)
Γ5 58 0.005 10−4 6 min 14 s (0.29)
Γ6 55 0.011 10−3 1 min 44 s (0.26)
Γ7 41 0.011 10−3 1 min 10 s (0.18)
Γ8 37 0.021 10−3 1 min 15 s (0.22)
fraction of the running time as required by the benchmark simultaneous solution method.
stemming from an intertemporal reallocation of resources do not cause problems of

convergence.
2.6 Concluding Remarks
This chapter develops a decomposition approach which can be applied to solve high-
dimensional static and dynamic general equilibrium models with many households.
We demonstrate its effectiveness for computing equilibria in large-scale OLG mod-
els which are infeasible for conventional simultaneous/direct methods. We find that
the proposed algorithm provides an efficient and robust way to approximate gen-
eral equilibrium in models with a large number of heterogeneous agents if income
effects remain sufficiently weak. The appropriateness of the solution method there-
Table 2.3 Convergence behavior in the presence of strong income effects
ν,α Number of iterations Approx. error ek Max. distance τ k CPU computing

(H = 50) (last iteration) (last iteration) time
0.50 , 0.80 33 0.015 10−3 1 min 06 s (0.17)
0.25 , 0.80 30 0.035 10−3 1 min 05 s (0.18)
0.80 , 0.50 42 0.014 0.013 1 min 27 s (0.19)
0.80 , 0.25 53 0.042 0.037 1 min 33 s (0.25)
0.50 , 0.50 42 0.117 0.011 1 min 15 s (0.23)
0.25 , 0.25 47 0.171 0.015 1 min 42 s (0.25)
fraction of the running time as required by the benchmark simultaneous solution method.
fore depends on the characteristics of the underlying model and the nature of the
implemented policy shock.
We believe that the approach can be beneficial for a wide range of economic
applications. In particular, it is advantageous for modeling tasks which necessitate
to economize on the dimensionality of the corresponding numerical problem. Po-
tential applications may include multi-country and multi-sectoral OLG models, and
analyses of relevant policy issues—such as, e.g., population aging, trade policy, and
poverty—which require detailed account of the distributional effects on a household
level while at the same time taking into account general equilibrium effects. More-
over, the decomposition approach may prove useful for the further development of
fully-integrated static and dynamic microsimulation models that incorporate the es-
sential macroeconomic linkages required for a comprehensive policy analysis.
Chapter 3
Trade Liberalization and Global Demographic
Change: A Quantitative Assessment
3.1 Introduction
The developed world stands at the fore of a historically unprecedented demographic

transition. Over the next several decades the number of elderly in the U.S., the
EU, and Japan will more than double. A salient feature of this global demographic
change is the fact that population aging will occur at differing paces and with dif-
fering intensities in the industrialized countries of the world. Significant aging is
already underway in some economies, for example Germany, Italy, and Japan. Ma-
jor demographic changes in the U.S. and China begin in the second decade of the
21st century (Figure 3.1). With a still longer lag, the demographic trends will be
manifest in developing economies as well. The presence of globally unsynchro-
nized aging patterns and the ongoing globalization of the world economy make it
necessary to enhance our understanding of the interaction of demographic factors
and international capital, labor, and commodity flows.
While the existing literature consistently identifies the presence of globally un-
synchronized aging patterns as an important driving force of cross-border flows of
capital (see, e.g., Attanasio and Violante (2005), Börsch-Supan et al. (2006), IN-
GENUE (2001)) and labor (see, e.g., Fehr et al. (2004b)), it—quite surprisingly—
overlooks its implications for international trade in goods. This chapter aims to fill
this void by developing a computable dynamic Heckscher-Ohlin model with over-
lapping generations (OLG) to evaluate the welfare effects of trade liberalization in
the presence of global demographic change. The purpose of our analysis is twofold.
First, we demonstrate that unsynchronized regional demographic patterns emerge
as a potential determinant of international trade flows. Then, we ask whether trade
liberalization under these circumstances can be beneficial. Based on standard neo-
classical trade theory, international trade economists typically argue that a country
is better off under an open trade regime relative to autarky.1 Exploiting the substan-
tial amount of household heterogeneity present in the model, it is possible to derive
1 There is a vast literature which tries to assess whether trade liberalization is beneficial. Among
those which tend to find a positive effect, are, e.g., Edwards (1993), Frankel and Romer (1999),

44 3 Trade Liberalization and Global Demographic Change: A Quantitative Assessment
7 5
C h in a
E u ro p e
W o r k in g - a g e p o p u la tio n r a tio ( in % ) F +G + I
7 0
J a
p a n
N o r th A m e r ic a
6 5
6 0
5 5
5 0
0
2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0
Y e a r
Fig. 3.1 Unsynchronized global aging patterns
Note: The working-age population ratio is defined as the population aged between 15-64 as a frac-
tion of the total population. ’F+G+I’ denotes the (unweighted) country average for France, Ger-
many, and Italy. Source: Own calculations based on United Nations, World Population Prospects:
The 2004 Revision. Medium projection variant.
welfare statements with respect to the inter- and intragenerational distribution of

welfare gains and losses across regions. In contradiction to the “standard view” that
international trade is Pareto-superior, we find that trade liberalization in the pres-
ence of globally unsynchronized demographic patterns does not necessarily imply
welfare gains, i.e. openess may be immiserizing. This holds both for the household
and social level, where in the latter case we use a range of different social welfare
functionals to check for the sensitivity of utility aggregation across time and house-
hold types.
There are several innovations in this chapter which set it apart from the existing
literature. First, we develop an augmented version of the canonical Heckscher-Ohlin
model which combines key elements of the factor proportions theory of international
trade with a computable OLG model in the tradition of Auerbach and Kotlikoff
(1987). Such a framework enables to study the interaction of demographic change
and international trade, and furthermore, introduces a role for relative prices and the
sectoral allocation of resources to shape the economic response to demographic
change. By adopting a standard macroeconomic single-commodity view of the
world, existing studies (Attanasio and Violante (2005), Börsch-Supan et al. (2006),
and Fehr et al. (2004b)) are neither capable of taking into account the impacts of
relative price changes nor can they shed light on the patterns of demographically-
induced trade in goods that are produced with different factor intensities.
and Glenn Harrison and Tarr (1997). Of course, this view has been subject to criticism. See, e.g.,
criticisms by Rodrik (1992) and Harrison and Hansen (1999).
3.1 Introduction 45
The second innovation of this chapter is to analyze the distribution of gains from
trade, both across time and generations of households and within each age group.
We are not aware of any similar attempt in the literature. Besides the heterogeneity
of age among overlapping generations, the model also features a substantial amount
of intra-cohort heterogeneity: household types differ with respect to age-specific la-
bor productivity and other key parameters governing the relative magnitudes of intra-
and intertemporal income and substitution effects. Third, and in terms of computa-
tional methodology, we employ the decomposition algorithm proposed in Chapter 2
that approximates the equilibrium allocation of the OLG economy by solving a se-
quence of appropriately chosen two-country Ramsey growth models. Despite of the
large dimensionality of the numerical problem at hand—resulting from the system
of overlapping generations and the two-country setup—this decomposition method
makes it possible to compute the transitional and steady state equilibrium effects of
all endogenous model variables in response to a demographic shock.
The results of this chapter are as follows. Regionally unsynchronized demograph-
ics patterns lead to the emergence of international trade flows. This result is based on
a simple yet convincing model mechanism. In a nutshell, an economy with a grow-
ing fraction of older people is bound to increase its accumulation of capital and
bound to decrease its aggregate labor supply. Capital becomes abundant relative to
labor because life-cycle savings and labor supply behavior of overlapping genera-
tions entails that older households tend to hold more assets and work less compared
to younger ones. Factor prices change accordingly to reflect the varying scarcity of
factors of production, i.e. wages go down and real interest rates increase. This in turn
creates differences in production costs of commodities that are produced with dif-
ferent factor intensities. The induced sectoral change is characterized by a relative
contraction (expansion) of the labor-intensive (capital-intensive) sector. Under au-
tarky, differences in demographic patterns across regions translate into international
differences in the relative abundance of factors of production: a relatively fast aging
country becomes capital-abundant and labor-scarce vis-á-vis a slow aging country.
Under such circumstances, opening up a country for trade leads to the emergence of
demographically-induced Heckscher-Ohlin trade flows.
If demographic differences emerge as a potential determinant of international
trade flows, the question arises whether a country or a region can benefit from dif-
fusing part of its demographic shock abroad by means of liberalizing its trade policy.
Since trade creates a tendency to reduce the dispersion in international factor and
commodity prices, opening up an economy for trade might “cushion” the adverse
consequences of population aging. However, as real wages and interest rates move
in different directions the overall effect on income and welfare is not unambiguous.
Moreover, the dynamic paths of equilibrium factor prices hinge on the extent and
timing of the demographic change in both regions. Thus, the qualitative and quanti-
tative effects from factor price changes will be distinct for each generation. Lastly,
households are not only heterogeneous with respect to their age but also exhibit fun-
damental differences in preferences and ability. This point is taken into account by
allowing for 10 different household types within each generation.
In contrast to what one would expect from standard neoclassical trade theory,
gains from trade in the presence of unsynchronized global aging patterns are not
guaranteed, i.e. openess may be immiserizing. This is a result of the evolution of
autarky-trade factor price differentials during the demographic transition. We find
that, for the fast aging region, trade liberalization is only beneficial for current old
generations that are born before and in the beginning of the demographic transition.
Future generations of all household types stand to incur substantial utility losses.
The intra-generational distribution of welfare gains and losses depends on the level
of labor productivity and the propensity to save throughout the life cycle. “Poor”
households, i.e. low-skilled and asset-poor households, tend to be relatively worse
off. We perform a systematic sensitivity analysis over a broad range of empirically
plausible parameters and find that there is a 80, 7% probability for households in the
fast aging region not to gain from trade liberalization. Moreover, looking at the bene-
fits of trade from a country/region perspective, we find that aggregate social welfare
gains require unrealistically high discount rates of about 8% and more. Despite of
the lack of social desirability for an open trade regime, the political assessment of
trade liberalization by means of an “hypothetical democratic referendum” under-
taken at the beginning of the demographic transition would support a liberal stance
of trade policy at the expense of future generations.
A substantial and growing literature has been calling attention to the economic
implications of unsynchronized global aging patterns in open economies. Besides
empirical studies2 computable overlapping generations (OLG) models have emerged
as the dominant analytical tool. For instance, Attanasio and Violante (2005), Feroli
(2003), Brooks (2003), and Domeij and Floden (2004) overwhelmingly find that
unequal demographic trends across countries can potentially induce global capital
flows if capital markets are integrated.3 A second strand of the literature analyzes the
role of pension reform and associated savings patterns for international capital flows
in the light of population aging (Attanasio and Violante (2005), Börsch-Supan et al.
(2006), INGENUE (2001)) and finds that capital flows from fast aging countries to
the rest of the world will initially be substantial but that trends are reversed when
aging progresses and households decumulate savings. Moreover, the status quo of
public pension systems is shown to crucially determine the magnitudes of interna-
2 See Bryant and McKibbin (1998, 2003) for good surveys of multi-country macroeconometric
simulation models that incorporate demographic change.
3 For example, Feroli (2003) uses a multi-region OLG model that is calibrated to match demo-
graphic differences among the major industrialized countries over the past 50 years and finds that
demographic differences can explain not all but some of the observed long-term capital movements;
Brooks (2003) finds that retirement saving by aging baby boomers will raise the supply of capital
substantially above investment in both the European Union and North America, causing both re-
gions to export large amounts of capital to Latin America and other emerging markets in the years
ahead. Beyond 2010, however, baby boomers in the European Union and North America will dis-
save in retirement, causing both regions to become capital importers. This shift will be financed by
capital flows from Latin America and other emerging markets, while Africa will remain dependent
on foreign capital for the foreseeable future because of continued high population growth. Domeij
and Floden (2004) empirically test to what extent international capital flows predicted by the model
match historically observed current account positions and find that a small but significant fraction
of international capital movements can be explained by the simulation model.
3.2 Model Formulation 47
tional capital movements. A series of papers by Fehr, Jokisch and Kotlikoff (2003),
Fehr et al. (2004a), and (n.d.) develop closed- and open economy OLG models
that allow, among many other features, for joint mobility of capital and labor across
regions. For instance, Fehr et al. (2004b) find that even a significant expansion of
immigration, whether across all skill groups or among particular skill groups, will
do remarkably little to alter the major capital shortage, tax hikes, and reductions in
real wages that can be expected along the demographic transition.
The rest of this chapter is organized as follows. Section 3.2 sets out the ana-
lytical framework. Section 3.3 explains our calibration strategy and specifies the
region-specific demographic dynamics. Section 3.4 presents the main model results
looking at the economic implications of unsynchronized global aging patterns under
autarky and trade, and also discusses the inter- and intragenerational distribution of
gains from trade. Section 3.4.5 performs a number of sensitivity analyses to pro-
vide a comprehensive quantitative assessment of trade liberalization under global
demographic change. Section 3.5 concludes.
3.2 Model Formulation
To provide a quantitative assessment of trade liberalization under global demo-

graphic change, we develop a numerical 2 × 2 × 2 (two regions–two factors–two
commodities) dynamic general equilibrium model that combines elements of the
factor-proportions theory of international trade with an OLG framework in the tra-
dition of Auerbach and Kotlikoff (1987).4 To isolate the effects of globally unsyn-
chronized aging patterns, we adopt the simplest possible model structure and use a
neoclassical constant-returns-to-scale growth model where all markets are perfectly
competitive. There is no aggregate or household-specific uncertainty. Time is dis-
crete and extends to infinity, t = 0, . . . , ∞. The two regions, indexed by r, s = a, b,
are assumed to be identical with respect to production technologies (and structure)
and household preferences. Within regions, overlapping households differ with re-
spect to labor productivity and a number of behavioral parameters that govern the
intra-period and life-cycle behavior. The two regions differ only with respect to the
exogenously imposed population dynamics.
International borrowing and lending is not permitted which implies in this model
that trade is balanced in each period. In doing so, we focus on the international ex-
change of goods as the sole link between regions and therefore rule out international
capital flows. Moreover, we do not consider any form of government activity and in
particular abstract from a public sector pension system. It can be argued, however,
4 In the international trade literature, OLG models are still used very rarely. Exceptions are models
that have been put forward by Mountford (1998), Sayan (2005), and Bajona and Kehoe (2006)—
all extending the seminal contribution by Galor (1992) to a two-country context. To maintain an-
alytical tractability, however, they abstract from a number of structural model components, e.g.,
multi-period lived agents and endogenous labor supply, that are pivotal for the type of analysis we
carry out here.
that the model describes a world where a fully-funded pension system is in place that
implicitly operates through the (private) life-cycle savings behavior of households.
3.2.1 Heterogeneous Households
Households live over a deterministic lifespan of a = 0, . . . , N periods. A generation

g = 0, . . . , ∞ is born at the beginning of each year t = g. Generations born prior to
year zero and that are alive in the first model period are indexed by −N, . . . , −1.
Within each generation, a household of type h, h = 1, . . . , H, is characterized by the
following set of socio-economic characteristics:
Ωh = {Πh , σh , νh , αh } (3.1)
where Πh denotes a labor productivity profile over the life cycle, σh is the intertem-
poral elasticity of substitution, σcl,h = 1/(1 − νh ) is the elasticity of substitution
between consumption and leisure, and αh determines the relative importance of ma-
terial consumption vis-à-vis leisure consumption. The presence of low and high-
skilled workers as well as different preferences with regard to the substitutability
of intra- and intertemporal consumption implies different savings and consumption
behavior over the life cycle that in turn give rise to qualitatively and quantitatively
different welfare implications of trade liberalization for households (for more details
on the empirical specification of household parameters see section 3.3.1). Note that
this setup implies that at each point in time there are H ×(N +1) different household
types that coexist. In the numerical examples below, we set N = 14 and H = 10, so
that H × (N + 1) = 150.
In each period over the life cycle households are endowed with units of time that
they allocate between labor and leisure. Households are assumed to be for-ward-
looking individuals that form rational point expectations (perfect foresight) over
the infinite horizon. Lifetime utility of generation g and type h in region r, ug,h,r ,
is additively separable over time and is of the constant-intertemporal-elasticity-of-
substitution form (CIES). The representative agent of each generation and type
chooses optimal consumption and leisure paths over his life cycle subject to lifetime
budget and time endowment constraints. The optimization problem for generation g
and household type h in region r is given by:
g+N t−g 1−σ −1

1 zr,g,h,th
max ur,g,h zr,g,h,t = ∑
cr,g,h,t , `r,g,h,t t=g 1+ρ 1 − σh−1
1
νh νh νh
s.t. zr,g,h,t = αh cr,g,h,t + (1 − αh ) `r,g,h,t
g+N g+N
∑ pr,a,t cr,g,h,t ≤ pr,k,t kr,g,h,g + ∑ pr,l,t πg,h,t (ωr,g − `r,g,h,t )
t=g t=g
`r,g,h,t ≤ ωr,g
cr,g,h,t ≥ 0 , `r,g,h,t ≥ 0 . (3.2)
Here, material consumption c and leisure consumption ` are combined to form a

composite consumption good z.5 ρ is the utility discount factor, and pr,x,t , x =
{a, k, l}, denote the price for the output good, the purchase price of capital, and
the wage rate, respectively. πg,h,t is an index of labor productivity over the life cycle
and ωr,g denotes the periodic time endowment of generation g. All household types
within a generation are of equal population size. The present value of total consump-
tion expenditure over the lifetime cannot exceed the present value of labor income.
This rules out that households die in debt. In each period of the life cycle, time allo-
cated to leisure consumption cannot exceed the total time endowment. Choices for
material and leisure consumption are restricted to be nonnegative.6
kr,g,h,g denotes the capital holdings of generation g at the beginning of life t =
g. Initial old generations, i.e. generations born prior to period zero, are endowed
with a non-zero amount of capital. The initial distribution of capital across these
generations is selected such that the economy is on a balanced growth path (for
details on the calibration procedure see Appendix 3.5.1). We assume that newborn
households enter with zero capital: kr,g,h,g = 0, ∀ g ≥ 0, and ∀ h.
The time endowment of a generation (ωr,g ) evolves according to:
ωr,g+1 = (1 + γr,g ) ωr,g (3.3)
where γr,g is the region-specific and time-dependent fertility rate. The size of the
generation born at the beginning of year zero is normalized to unity. Note that there
is no growth in time endowments over the life cycle. Thus, while the number of
households across generations increases over time, the size of a cohort over its life
cycle remains constant. Total population Nr,t in region r at time t is given by Nr,t =
H ∑tg=t−N ωr,g . The population growth rate γer,t can thus be defined as:
Nr,t+1
γer,t = −1. (3.4)
Nr,t
To maintain a balanced growth path, the age structure of the population has to be
stationary which requires that γ = γe = const.7
5 Households first decide how to allocate their lifetime income over time. Given the expenditure
for z, households decide in a second stage how much to spend on consumption and leisure. The
assumption of multi-stage budgeting is innocuous if and only if the utility function u is weakly
separable and the sub-utility functions z are homothetic. Both conditions are satisfied in this model.
6 Note that due to the convex structure of CES-preferences the nonnegativity constraints on c and
l are never binding in the optimum.

7 Furthermore, it is straightforward to show that the lower γ, the lower is γe and the lower is also
the working-age population ratio, denoted by Wr,t , which we define here as the number of people
3.2.2 Firms and Production Structure
Production occurs within a period and technologies are stationary over time.8 Com-
petitive firms in both regions have access to two linearly homogenous produc-
tion technologies of the constant-elasticity-of-substitution (CES) form, index-ed by
i, j ∈ {1, 2}, that combine services of capital, Kt,r,i , and labor, Lt,r,i to produce a
homogenous good:
1/εi
εi εi
Yi,r,t = αi Ki,r,t + (1 − αi ) Li,r,t (3.6)
where αi is a sector-specific share parameter and where σY,i = 1/(1 − εi ) is the

elasticity of substitution. For future reference, let pi,t denote the price of the traded
good i. Factors of production can move freely across sectors within a region but are
assumed to be immobile internationally. We make the assumption that production
of Y1,r,t is capital-intensive relative to Y2,r,t :
α1 > α2 . (3.7)
Capital intensity reversals at all factor and commodity prices are ruled out by the
functional form of (3.6) and the additional assumption that ε1 = ε2 .9 This assump-
tion is central to the results and determines along with changes in the relative abun-
dance of factors the structure of trade patterns.
The sectoral output good Yi,r,t can be traded on international markets. There are
no transportation costs or any other type of trade barriers. Domestically produced
and imported quantities of Yi,r,t are combined by a CES-aggregator to form a final
good At,r :
1/εa
Ar,t = αa aε1,r,t
a
+ (1 − αa ) aε2,r,t
a
(3.8)
where αa is a share parameter and σa = 1/(1 − εa ) denotes the elasticity of substi-

tution. ai,r,t denotes the amount of the tradable good i used in the production of Ar,t .
Let pr,a,t denote the price for the final good in region r. The final good can be used
for domestic consumption and investment purposes. For future reference, let pr,re,t
denote the capital rental rate.
aged between 0 − 0.6 N as a fraction of the total population, i.e. :
H ∑tg=t−N+0.6 N ωr,g
Wr,t = . (3.5)
Nr,t
8 We solely focus on the role of population aging in determining growth dynamics and do not
consider technological change. Adding another exogenous engine of growth does not change the
results with respect to the implications of differential population dynamics.
9 See Wong (1990).
3.2.3 Feasibility Conditions and Model Closure
In the following, let upper case letters denote the respective aggregate variable.
Given intergenerational heterogeneity, we impose the following feasibility condi-
tions to ensure that individual household behavior is consistent with the aggregate
economy:
t H
Lr,t = ∑ ∑ ωr,g,t − `r,g,h,t (3.9)
g=t−N h=1
t H
Ir,t = ∑ ∑ ir,g,h,t (3.10)
g=t−N h=1
t H
Kr,t = ∑ ∑ kr,g,h,t (3.11)
g=t−N h=1
t H
Cr,t = ∑ ∑ cr,g,h,t . (3.12)
g=t−N h=1
The feasibility conditions for factors of production are:
K1,r,t + K2,r,t ≤ Kr,t (3.13)
L1,r,t + L2,r,t ≤ Lr,t . (3.14)

World markets for traded good i, i = 1, 2, in period t, clear if:
∑ Yi,r,t = ∑ ai,r,t . (3.15)

r r
The law of motion for the aggregate capital stock for each region is given by:
Kr,t+1 = (1 − δ ) Kr,t + Ir,t . (3.16)
In each period t, the composite consumption good can be used for consumption and
investment:
Ar,t = Cr,t + Ir,t . (3.17)
Finally, and to close the model, we impose the restriction that international borrow-
ing and lending is not permitted.10 In addition, we assume that neither of the regions
has fiat money, i.e. ∑0g=−N kr,g,h,g = (1 + r̄) K r . Here, r̄ and K r denote the steady state
interest rate and the base year capital stock in region r, respectively. The assumption
that international trade is balanced in each period can then be written as:
pr,a,t (Ar,t −Cr,t − Ir,t ) = 0 . (3.18)
10 Bajona and Kehoe (2006) show in a similar setting that if international borrowing and lending
takes place, i.e. a country can run a temporary trade imbalance, the equilibrium patterns of capital,
international borrowing and lending, and trade are indeterminate.
This condition can be derived by rewriting the lifetime budget constraint in (3.2) as
a series of periodic budget constraints, aggregating the periodic constraints over all
generations and household types that are alive at a given point in time, and finally
making use of Euler’ theorem for homogeneous functions.
3.2.4 Equilibrium
Definition 1: Given initial endowments of of capital, kr,g,h,g , for generations g =

−N, . . . , −1, for all h, i.e. those born prior to year zero, a competitive equilibrium
∞
is a collection of choices for households {cr,g,h,t , `r,g,h,t }t=0 , t = g, . . . , g + N, for
all g = −N, . . . , ∞, ∞
for all h, and for the representative firm in each traded industry
{Yi,r,t , Ki,r,t , Li,r,t }t=0 , i = 1, 2, and for the representative firm in the final goods sec-
∞ ∞
tor, {Ar,t ,Y1,r,t ,Y2,r,t }t=0 , and prices pr,a,t , pr,l,t , pr,re,t , pr,k,t , pi,t }t=0 , i = 1, 2, and
for all regions, r = a, b, such that:
∞
1. Given prices {pr,a,t , pr,l,t , pr,re,t , pr,k,t , pi,t }t=0 , the choices {cr,g,h,t , `r,g,h,t }
solve the respective optimization problem in (3.2).
∞
2. Given prices {pr,a,t , pr,l,t , pr,re,t , pr,k,t , pi,t }t=0 , the representative firm in each
traded industry, i = 1, 2, and in the final goods sector maximizes profits, i.e.
{Ki,r,t , Li,r,t } ∈ arg maxKi,r,t ,Li,r,t ≥0 pi,t Yr,i,t (Ki,r,t , Li,r,t ) − pr,re,t Ki,r,t − pr,l,t Li,r,t
and
{a1,r,t , a2,r,t } ∈ arg maxa1,r,t ,a2,r,t ≥0 pr,a,t Ar,a,t (a1,r,t , a2,r,t ) − p1,t a1,r,t − p2,t a2,r,t ,
respectively.
∞
3. The sequences of household choices {cr,g,h,t , `r,g,h,t }t=0 , and production
∞ ∞
plans, {Yi,r,t , Ki,r,t , Li,r,t }t=0 , and {Ar,t ,Y1,r,t ,Y2,r,t }t=0 , satisfy the feasibility con-
ditions (4.33)–(3.18).
n
Definition 2: A steady state is a collection of choices for households cbr,g,h,t , `br,g,h,t
∞ ∞
t=0 , and for the representative firm in each traded industry {Yi,r,t , Ki,r,t , Li,r,t }t=0 ,
b b b
and for the representative firm in the final goods sector, {A br,t , Yb1,r,t , Yb2,r,t }∞ , and
∞
t=0
prices pr,a,t , pr,l,t , pr,re,t , pr,k,t , pi,t }t=0 , that satisfy the conditions of a competitive
equilibrium for appropriate initial endowments of capital kr,g,h,g = b kr,g,h,g , and where
the age structure of the population is stationary, i.e. γ = γe = const. Here, we set
νt = νb for all t, where ν represents a generic variable.
3.3 Calibration and the Nature of Demographic Shocks 53
Table 3.1 Base case parametrization of intracohort household heterogeneity
Household type σh σcl,h αh Πh = {ζscale,h , ζage,h , ζage2,h }

h = 1 (poorest household) 0.50 0.50 0.45 {0.50, 0.0450, 0.00400}
h=2 0.60 0.60 0.50 {0.55, 0.0475, 0.00400}
h=3 0.70 0.70 0.55 {0.60, 0.0500, 0.00375}
h=4 0.80 0.80 0.60 {0.65, 0.0525, 0.00375}
h=5 0.90 0.90 0.65 {0.70, 0.0550, 0.00355}
h=6 1.00 1.00 0.70 {0.75, 0.0575, 0.00355}
h=7 1.20 1.10 0.75 {0.80, 0.0600, 0.00325}
h=8 1.30 1.20 0.80 {0.85, 0.0625, 0.00325}
h=9 1.40 1.30 0.85 {0.90, 0.0650, 0.00300}
h = 10 (richest household) 1.50 1.40 0.90 {1.00, 0.0675, 0.00300}
3.3 Calibration and the Nature of Demographic Shocks
The model outlined above does not possess an analytical solution and therefore has
to be solved numerically. Appendix 3.5 formulates the dynamic general equilibrium
of the model as a mixed-complementary problem (MCP) and provides more details
on the steady state calibration of the model and the solution algorithm that is used
to compute the transitional dynamics and steady state effects of the demographic
simulation experiments. For solving the model, we use the decomposition algorithm
presented in Chapter 2. In the present context, the equilibrium of the OLG economy
is approximated by solving a sequence of appropriately chosen two-country, two-
sector Ramsey growth models.
3.3.1 Calibration Strategy
Given the oversimplified and illustrative nature of the model, we adopt a naive cali-
bration approach that builds on standard values from the literature.11 Section 3.4.5
performs a number of sensitivity analyses to check for the robustness of the results.
For the technology parameters, we set α1 = 0.7, α2 = 0.3, 1/(1 − εi ) = 1, i = 1, 2,
αa = 0.5, 1/(1 − εa ) = 1, and δ = 0.1.12 The model is calibrated to a steady state
equilibrium where we assume that along the baseline path quantities grow with
1 + γ̄ = 1.02 and present value prices decline with 1 + r̄ = 1.1. We reconcile in-
dividual decisions by the OLG households with aggregate data in the base year by
11 Numerical values for the exogenous model parameters are taken from Backus, Kehoe and Kyd-
land (1992) and Ambler, Cardia and Zimmermann (2002).
12 For the base case, we assume Cobb-Douglas technologies for Y
i,r,t and Ar,t , i.e. εi = εa = 0. For
these values the CES functions in (3.6) and (3.8) are not defined. However, as εi and εA approach
zero, the isoquants of the CES production functions look very much like the isoquants of the Cobb-
Douglas production function.
6 c o n s u m p tio n
la b o r in c o m e p r o d u c tiv ity in d e x
1 0 0
c a p ita l in c o m e w o r k in g tim e ( in % )
le is u r e tim e ( in % )
in d e x ( fir s t p e r io d c o n s u m p tio n = 1 )
in d e x ( fir s t p e r io d p r o d u c tiv ity = 6 0 )

a s s e ts s to c k
8 0
4
6 0
4 0
2
2 0
0 0
0 5 1 0 1 5 0 5 1 0 1 5
A g e in life c y c le ( b e g in n in g o f p e r io d ) A g e in life c y c le ( b e g in n in g o f p e r io d )
(a) Baseline profiles and asset stocks (b) Productivity index and allocation of time
Fig. 3.2 Calibrated life cycle behavior for h = 3 (initial steady state)
Note: Optimal life cycle behavior for all generations and household types along the baseline path is
derived in the first calibration step using a steady state assumption. For details see Appendix 3.5.1.
The household calibration model is parameterized as shown in Table 3.1.
calibrating the discount factor ρ such that the sum of the value of individual con-
sumption demands equals aggregate consumption. Likewise, to match individual
asset holdings with the value of the aggregate capital stock in the base year, we in-
troduce a scaling factor on the time endowment of households and select its value
accordingly.13
Naturally, intra-period and intertemporal household behavior crucially hinges on
assumptions regarding various elasticities parameters. The way of parameterizing
household behavior takes the extreme standpoint that the uncertainty of empirical
parameter estimates is to a large extent a result of differences in underlying house-
hold preferences. Hence, we incorporate “uncertainty” in a direct fashion by allow-
ing for different preferences within each age group. In 3.4.5 we use Monte-Carlo
simulation methods to check for the general robustness of results over a broad range
of empirically plausible parameter configurations.
Following Auerbach and Kotlikoff (1987), we assume that labor productivity fol-
lows a hump-shaped profile over the life cycle:
2
πa,h = ζscale,h e(4.47 + ζage,h a − ζage2,h a ) / e4.47 . (3.19)
For each household type, we slightly perturb their numerical specification thereby
allowing for differences in labor productivity. Labor productivity across generations
of a given household type is assumed to be identical. Table 3.1 shows the parameter
specification which is used in the numerical simulation later on. The model is solved
in one-year intervals and N = 14 which implies that households live for 15 years.
13 Since income is linear in this scaling factor and demand is linear in income, such a scaling
parameter has no economic significance. For more details of the steady state calibration procedure
see Appendix 3.5.1.
3.3 Calibration and the Nature of Demographic Shocks 55
2 ,0 H o u s e h o ld ty p e :
1 (p o o re s t)
2
o f e c o n o m y - w id e a s s e ts
1 ,5 3
4
5
6
1 ,0 7
8
9
1 0 ( r ic h e s t)
0 ,5
%
0 ,0
0 5 1 0 1 5
A g e in life c y c le ( b e g in n in g o f p e r io d )
Fig. 3.3 Baseline equity shares by household type and age
Note: The plot shows the amount of assets held by different household types through the life cycle
as a percentage fraction of economy-wide assets (along the steady state baseline path).
This is found to be sufficient for generating a meaningful life cycle behavior on the
part of the households and for studying the implications of population aging.
Figure 3.2, Panel (a), shows the calibrated steady state income and consumption
profiles and asset stocks over the life cycle for a household of type h = 3. For the in-
terpretation of the results later on, it is important to understand the nature of the life
cycle behavior which builds on the foundation developed by Modigliani and Brum-
berg (1954). Households arrange savings so as to smooth consumption over their
lifetime—as it is implied by the intertemporal Euler equation. Due to the hump-
shaped productivity profile, time devoted to labor and consequently labor income is
increasing in the first years and then decreases—as it is implied by the intratempo-
ral Euler equation for leisure. Households accumulate assets in younger to middle
ages and run down their asset positions when being old; capital income evolves ac-
cordingly. In the last period of the life cycle, consumption is entirely financed out
of savings since households optimally chose not to earn labor income. Figure 3.2,
Panel (b), shows the allocation of leisure and working time over the life cycle. With
the given parametrization, labor supply drops to zero in the two last periods of the
life cycle with the reservation wage exceeding the market wage. An attractive fea-
ture of this analysis is the use of complementarity programming to accommodate
endogenous regime shifts—as here, for instance, optimal retirement decisions by
households.
As a consequence of the differences in intra- and intertemporal behavior of house-
holds, there are large dissimilarities with respect to the optimal wealth accumulation
path. Figure 3.3 illustrates this point and shows the amount of assets that is being
held by each household type throughout the lifetime as a fraction of economy-wide
assets.
2 ,0
fa s t a g in g r e g io n 7 2 fa s t a g in g r e g io n
s lo w a g in g r e g io n s lo w a g in g r e g io n
W o r k in g - a g e p o p u la tio n r a tio ( in % )
P o p u la tio n g r o w th r a te ( in % )
1 ,5 7 1
1 ,0
7 0
0 ,5
6 9
0 ,0
0 5 1 0 1 5 2 0 2 5 3 0 3 5 0 5 1 0 1 5 2 0 2 5 3 0 3 5
T im e p e r io d T im e p e r io d
(a) Population growth rate (b) Working-age population ratio
Fig. 3.4 Demographic shocks and population aging
Note: Panel (a) shows the changes in the population growth rate γer,t as implied by the fertility rate
shocks. Panel (b) shows the impact on the working-age population ratio Wr,t .
3.3.2 Region-specific Population Dynamics
Population aging is modeled by assuming that fertility rates decrease over time.14
Shocks to the fertility rate rate alter the age composition of the population. Globally
unsynchronized aging patterns are modeled by assuming that the speed of decline in
fertility rates varies across regions. Region a is taken to be the fast aging region vis-
à-vis a slow aging region b. In the initial steady state, both regions are characterized
by an identical fertility rate γ̄. From year zero onwards population dynamics begin
to diverge and both regions experience a linear decline in fertility rates. Eventually,
fertility rates in both region converge to a new and common long-run level γ SS < γ̄.
More specifically, the time profile for the fertility rates in region r is given by:

 γ̄ if g ≤ 0
γr,g = γ̄ − ∆r t if 0 < g ≤ Br (3.20)
 SS
γ if g > Br ,
where ∆a = 0.02, ∆b = 0.01, Ba = 10, Bb = 20. Without loss of generality, we set

γ SS = 0. Figure 3.4 shows the implied changes in population growth rates and the
working-age population ratio. Note that γ SS < γ̄ implies that the fraction of old peo-
ple in the new steady steady is lower than in the initial equilibrium. Also, it is im-
portant to bear in mind that the demographic transition extends beyond the point in
time where fertility rates have converged to a new long-run level: it nearly takes a
lifetime of a generation until the age structure becomes stationary again.
14 The number of periods over the life cycle is kept constant. Hence, we do not consider changes
in longevity.
3.4 Model Results and Discussion 57
3.4 Model Results and Discussion

We now present simulation results obtained from imposing differential population
dynamics under alternative assumptions about the integration of international goods
markets. As a starting point and to understand why differences in regional popula-
tion dynamics prepare the ground for Heckscher-Ohlin trade patterns, it is helpful
to first look at each of the two regions under autarky. Such a situation might for ex-
ample reflect prohibitively high transportation costs or the presence of protectionist
trade policies. Under autarky, we compare the consequences of demographic change
to the initial steady state situation. Second, we look at the full two-country model
where international goods markets are perfectly integrated. Here, the autarky case
serves as a benchmark.
3.4.1 Demographic Change in a Two-Sector Economy Under

Autarky
Figure 3.5, Panels (a) – (c), show the evolution of key macroeconomic variables
for the fast aging region under autarky.15 A decline in fertility rates γ increases the
capital stock, consumption, and output, and decreases investment (all variables refer
to per capita terms). Moreover, the real wage rate increases whereas the real interest
rate declines.
There are a number of direct and indirect effects that explain these equilibrium
outcomes (the relative strength of each effect depends on the specific parametriza-
tion of the model—an issue which we will explore further in Section 3.4.5). As the
most direct effect, the decrease in γ leads to a decrease of the overall population
which means that existing resources have to be shared by less people. The implied
decline in the working-age population ratio means that the number of young relative
to the old has decreased. Since the propensity to save is higher for younger people,
and because older people tend to hold more assets than younger ones, investment
decreases and the capital stock increases (both in per capita terms).16 These shifts
in relative factor endowments affect real factor prices which in turn alter economic
incentives to accumulate capital and to supply labor. Both, the capital deepening and
the decline in the (potential) labor force makes labor scarce relative to capital, and
hence, the real wage rate increases while the real capital rental rate (as well as the
real interest rate which moves in parallel) decreases. Despite the decline in the labor
force, per capita output is shown to increase due to the increase in the per capita
15 Although this model features elastic labor supply on the part of the households, we do not
distinguish between the “per capita” and “per worker” concept. From a qualitative viewpoint both
concepts lead to identical results while quantitative differences are negligible.
16 The result of a higher steady state level of per capita capital and output in response to a perma-
nently lower population growth rate is also obtained in a Solow-Swan growth framework. In the
Ramsey model, however, changes in the population growth rate have only transitional effects on
these per capita variables since there is by construction no “leverage” for the compositional shift
in the age structure of a population. For more details see, e.g., Barro and Sala-i-Martin (2004).
1 2 4
8
s te a d y s ta te ( in % )
2
re a l w a g e ra te
4
c a p ita l p u r c h a s e r a te
r e a l c a p ita l r e n ta l r a te
0
0
c o n s u m p tio n
in v e s tm e n t
-4
D e v ia tio n fr o m
c a p ita l s to c k
o u tp u t -2
-8
-1 2
-4
0 1 0 2 0 3 0 4 0 0 1 0 2 0 3 0 4 0
(a) Per capita variables, fast aging region (b) Real factor prices, fast aging region
1 ,0 7
c o n s u m p tio n
in v e s tm e n t
6
c a p ita l
0 ,5 o u tp u t
5
4
0 ,0
3
fa s t a g in g r e g io n
-0 ,5 s lo w a g in g r e g io n
2
1
-1 ,0
0
0 1 0 2 0 3 0 4 0 0 1 0 2 0 3 0 4 0
(c) Per capita growth rates, fast aging region (d) Per capita capital stock, fast aging region
Fig. 3.5 Per capita macroeconomic variables under autarky
Note: The plots show the transition to a new long-run equilibrium in response to demographic
shocks as specified in eq. (3.20). Panel (a): Consumption is defined as total private sector consump-
tion. Investment is gross investment. Output is defined as the quantity of the composite good A
produced at a given point in time. Panel (b): Factor prices are nominal factor prices deflated by the
consumer price index.
capital stock and the fact that output has to be shared among less people. Finally,
since in this model population growth is the only engine of long-run growth, growth
rates of per capita variables converge back to zero in the new steady state equilib-
rium (Panel (c)). Section 3.4.5 demonstrates that these outcomes are qualitatively
robust over a broad range of parameter configurations that is supported by empirical
literature.
Factor price changes imply different costs of production for each sector and there-
fore bring about a sectoral change in the aging economy. Figure 3.6 shows that the
output of the capital-intensive sector expands relative to the labor-intensive sector
(Panel (a)) and that the relative price of the capital-intensive commodity declines
(Panel (b)). The movement in factor price changes is an instance of what is known
as the “Rybczynski effect”: the fall in the relative price of commodity 1 lowers the
real return to the factor used intensively in the production of that good, here capi-
tal, and hence the capital rental rate falls, and increases the real return to the other
factor, here labor, and hence the wage rate rises.17 Since in each period changes
in commodity prices are a weighted average of changes in factor prices, the wage
rate (capital rental rate) increases (decreases) in percentage terms by more than the
relative price of commodity 1.
We can summarize the key results of this section as follows:
1. Population aging leads to a higher per capita capital stock during the transition
and in the new long-run equilibrium.
2. In a two-sector economy in which sectoral output is produced with different fac-
tor intensities, population aging leads to a relative contraction (expansion) of the
labor-intensive (capital-intensive) sector. The real wage rate (capital rental rate)
increases (decreases) during the transition and in the new long-run equilibrium.
3.4.2 Globally Unsynchronized Aging Patterns and International

Trade
Differences in the extent and timing of aging patterns across regions lead to quanti-
tatively distinct responses in both economies. Figure 3.5, Panel (d), shows that the
capital deepening process is less pronounced in the slow aging region as compared
to the fast aging region. Since the working-age population ratio in the fast aging re-
gion is higher throughout the demographic (and economic) transition, the per capita
capital stock in the slow aging region is lower than in the fast aging region, i.e. the
slow (fast) aging region becomes relatively labor (capital) abundant. As a result,
the ”dampened Rybczynski effect is weaker for the slow aging region implying a
weaker relative expansion of the capital-intensive sector (see Figure 3.6, Panel (a)).
Under autarky, differences in relative factor endowments cause equilibrium fac-
tor prices to diverge (Figure 3.6). The wage rate (capital rental rate) in the capital-
abundant/labor-scarce region is higher (lower) than in the capital-scarce, labor-
abundant region. Despite identical production technologies in both regions, differ-
entials in factor prices imply different costs of production which in turn translate
into international relative price differences of sectoral output under autarky (Figure
3.6, Panel (b)). The fast aging region therefore has a cost advantage in producing the
capital-intensive commodity whereas the slow aging region has a cost advantage in
the production of the labor-intensive commodity. Hence, the relative price of com-
modity 1 in the fast aging region stays below the one in the slow aging region as
long as differences in relative factor endowments across regions are sustained.
Divergence of relative commodity prices under autarky create incentives for
trade. If international trade is liberalized, each region will export the good where
it has a cost advantage. Exploiting the higher relative price of commodity 1 in the
slow aging region, the fast aging, capital-abundant region consequently exports the
17Note that we only observe a ”dampened” Rybczynski effect due to feedback effects of induced
commodity price changes which cushion—but not reverse—the ”pure” Rybczynski effect that
would be obtained if prices were fixed. See, e.g., Jones (1965, pp.562).
0
a u ta r k y , fa s t a g in g r e g io n
a u ta r k y , s lo w a g in g r e g io n
tra d e
2
-1
1
a u ta r k y , fa s t a g in g r e g io n
a u ta r k y , s lo w a g in g r e g io n -2
0
0 1 0 2 0 3 0 4 0 0 1 0 2 0 3 0 4 0 5 0
(a) Relative size of sector 1 (b) Relative price of commodity 1
0
3 a u ta r k y , fa s t a g in g r e g io n
tra d e
-1
2
-2
1 a u ta r k y , fa s t a g in g r e g io n
tra d e
0 -3
0 1 0 2 0 3 0 4 0 5 0 0 1 0 2 0 3 0 4 0 5 0
(c) Real wage rate (d) Real rental rate of capital
Fig. 3.6 Sectoral change and impact on equilibrium commodity and factor prices
Note: The plots show the transition to a new long-run equilibrium in response to demographic
shocks as specified in eq. (3.20). The relative size of the capital-intensive sector 1 is measured as
the ratio of sectoral outputs. The relative price of commodity 1 is defined as the ratio of the price
for commodity 1 and 2. Real factor prices are nominal factor prices deflated by the consumer price
index.
capital-intensive commodity 1, whereas the slow aging, labor-abundant region ex-

ports the labor-intensive commodity 2. Each region specializes in the production of
the good which it can produce more efficiently thereby even more increasing pro-
ductivity of the factor used intensively in this sector. Comparing trade with autarky,
capital is more productive in the capital-intensive sector in the fast aging region and
is less productive in the labor-intensive sector in the slow aging region—vice versa
for the productivity of labor (not shown). Free trade establishes a common relative
price across regions where the autarky prices provide lower and upper bounds (Fig-
ure 3.6, Panel (b)). Trade in goods is a perfect substitute for trade in factors and
therefore leads under the assumptions of this model to the equalization of factor
prices (Figure 3.6).
Although immobile internationally, capital is shifted between regions to the ex-
tent that it is embedded in traded goods. By exporting the capital-intensive commod-
ity during the transition, the capital abundant region is thus characterized by a lower
capital stock per capita under trade as compared to autarky, whereas per capita cap-
ital in the labor abundant region, which exports the labor-intensive good, is higher
under trade as compared to autarky (not shown).
1. Globally unsynchronized aging patterns affect the relative abundance of factors
of production across regions and lead to differentials in commodity and factor
prices under autarky. The per capita capital stock in the fast aging region is higher
than in the slow aging region.
2. If international goods markets are integrated (and if goods are produced with dif-
ferent factor intensities), the presence of globally unsynchronized aging patterns
leads to demographically-induced Heckscher-Ohlin trade. The fast (slow) aging
region specializes in the production and export of the capital-intensive (labor-
intensive) commodity during the transition.
3.4.3 Welfare Effects of Trade Liberalization Under Global

Demographic Change
In contrast to what one would expect from standard neoclassical trade theory, mov-
ing from an autarky situation to a world where goods can move freely across bor-
ders does not unambiguously result in welfare gains on a household level. Depend-
ing on the particular set of socio-economic characteristics of a household type and
generation—including age, labor productivity and other principal characteristics
that determine intra- and intertemporal behavior—gains from trade are not guaran-
teed. Figure 3.7 shows the percentage change in Hicksian equivalent variation (EV)
by generation and household type for the fast aging region.18
On an intergenerational basis, trade liberalization in the presence of globally
unsynchronized aging pattern has very distinct quantitative and qualitative welfare
consequences for current and future generations. Depending on the specific house-
hold type, generations born in the run up to and the beginning of the demographic
transition gain (lifetime utility of generations g = −15, . . . , 8 increases) whereas gen-
erations born in the midst of the transition and thereafter (generations g > 9 for all
household types) stand to incur substantial utility losses. As the age structure of
populations in both regions converges, the adverse welfare effects for newly born
generations diminish.
On an intragenerational basis, whether welfare gains materialize for current old
generations depends on the particular household characteristics. Figure 3.8, Panel
(a), takes a cross-sectional view and shows the distribution of welfare changes across
household types for generation g = 5. It is evident that “poor” households, i.e. low-
skilled workers and those households that hold relatively few assets throughout their
life cycle, lose from trade liberalization whereas richer households gain overall.
18 Due to the artificial symmetry of this two-country model, welfare changes for the slow aging
region are diametrically opposed to what is observed in the fast aging region. In the following
discussion, we focus on the fast aging region.
0 ,8
H o u s e h o ld ty p e :
C h a n g e in H ic k s ia n e q u iv a le n t v a r ia tio n ( in % )
1 (p o o re s t)
0 ,4 2
3
4
0 ,0 5
6
7
-0 ,4
8
9
1 0 ( r ic h e s t)
-0 ,8
-1 ,2
-1 5 -5 5 1 5 2 5 3 5 4 5 5 5
G e n e r a tio n
Fig. 3.7 Intergenerational distribution of welfare effects by household types
Note: Changes in Hicksian equivalent variation resulting from a trade liberalization in the presence
of globally unsynchronized aging patterns. The graph shows welfare changes by generation and
household type for the fast aging region.
0 ,3
C h a n g e in H ic k s ia n e q u iv a le n t v a r ia tio n ( in % )
0 ,2
0 ,1
0 ,0
1 2 3 4 5 6 7 8 9 1 0
-0 ,1
H o u s e h o ld ty p e
-0 ,2
-0 ,3
-0 ,4
-0 ,5
Fig. 3.8 Intragenerational distribution of welfare effects (for g = 5)
Note: Changes in Hicksian equivalent variation resulting from a trade liberalization in the presence
of globally unsynchronized aging patterns across household types for generation g = 5, fast aging
region.
Why are there winners and losers from trade liberalization in the presence of glob-
ally unsynchronized aging patterns ? What explains that future generations will ex-
perience welfare losses whereas current old generations gain ? Why are low-skilled
workers and those households that exhibit relatively low levels of savings throughout
their lifetime most adversely affected by global demographic change ? The answers
lie in the evolution of autarky-trade factor price differentials. The pressure on real
factor prices that stems from the region-specific demographic change is mitigated
by the specialization patterns in production and the international exchange of goods.
G e n e r a tio n
0 ,5 0 (ty p e h = 1 ):
0 ,4 re a l w a g e ra te g = - 1 4
C h a n g e in m a te r ia l c o n s u m p tio n ( in % )
r e a l c a p ita l r e n ta l r a te g = - 1 3
g = - 1 0
0 ,2 5 g = - 8
g = - 6
a u ta r k y ( in % )
0 ,2
g = - 4
g = - 2
0 ,0 0
g = 0
g = 2
0 ,0
g = 4
-0 ,2 5 g = 6
C h a n g e fro m
g = 8
g = 1 0
-0 ,2 g = 1 2
-0 ,5 0 g = 1 4
g = 1 6
g = 1 8
-0 ,4 g = 2 0
-0 ,7 5
0 1 0 2 0 3 0 4 0 5 0 0 5 1 0 1 5 2 0 2 5 3 0 3 5
(a) Change in factor prices (b) Change in consumption (h = 1)
G e n e r a tio n 2 0 G e n e r a tio n
(ty p e h = 1 ): (ty p e h = 6 ):
0
g = - 1 4 g = - 1 4
C h a n g e in la b o r s u p p ly ( in % )
g = - 1 3 g = - 1 3
C h a n g e in la b o r s u p p ly ( in % )
1 5
g = - 1 0 g = - 1 0
-1
g = - 8 g = - 8
g = - 6 g = - 6
g = - 4 1 0 g = - 4
-2 g = - 2 g = - 2
g = 0 g = 0
g = 2 g = 2
-3 g = 4 5 g = 4
g = 6 g = 6
g = 8 g = 8
g = 1 0 g = 1 0
-4 g = 1 2 0 g = 1 2
g = 1 4 g = 1 4
-5
0 5 1 0 1 5 2 0 2 5 3 0 0 5 1 0 1 5 2 0 2 5 3 0
(c) Change in labor supply (h = 1) (d) Change in labor supply (h = 6)
Fig. 3.9 Factor price changes and impact on household decisions (trade vs. autarky)
Note: The plots show compare trade with autarky under population dynamics as specified in (3.20).
All plots refer to the fast aging region. Panel (a): Change in real factor prices. Panel (b): Change in
material consumption, cg,h,t , for household type h = 1. Panel (c) and (d): Change in labor supply,
ωg,t − `g,h,t , for household type h = 1 and h = 6, respectively.
International trade equalizes the real factor prices and therefore increases the real
capital rental rate and decreases the real wage rate in the fast aging region relative
to autarky (Figure 3.9, Panel (a)).
International trade can thus be viewed as a mechanism which arbitrages away
differences in global demographic patterns as the integrated world economy as a
whole now faces an “average demographic scenario” with factor and commodity
prices being averages of autarky equilibrium prices. Changes in real factors prices
alter the consumption and labor supply/leisure choices of households directly affect-
ing utility as in (3.2) and therefore explain why some households gain and others
lose.
3.4.3.1 Household Consumption and Labor Supply
To better understand the distribution of intra- and intergenerational welfare changes

from trade liberalization, this section studies in more detail how the global demo-
graphic transition affects household decisions on a micro level.
Consumption and labor supply decisions are equilibrium outcomes that de-
pend on a number of direct and indirect effects—some of them work in different
directions—and that are determined by key household parameters and by the mag-
nitude of prices changes that households experience over their lifetime.19 Consump-
tion choices over the life cycle of a generation are directly affected by changes in
the real interest rate since, firstly, for a given level of savings higher interest rates
make households wealthier (wealth effect) and, secondly, changes in the interest rate
affect the relative price of intertemporal consumption. Specifically, higher interest
rates imply that consumption today becomes more expensive vis-à-vis consumption
tomorrow, and hence households allocate consumption towards later periods of their
life (substitution effect). Second, there is an indirect effect on consumption which
stems from changes in the wage rate: for a given level of labor supply, lower wage
rates depress lifetime income and consumption therefore decreases (wage effect).
Labor supply decisions respond to changes in the real wage rate (price effect). The
intuitive case is that labor supply is increasing in the wage rate. Intertemporally op-
timizing households may, however, increase labor supply in response to a decline
in the wage rate so as to prevent large fluctuations in periodic income which would
be inconsistent with the objective of consumption smoothing. In such a case, leisure
consumption is a Giffen good. Interest rate changes also affect labor supply deci-
sions since for a given level of savings, higher interest rates imply that households
have become more wealthy, and because there is disutility from working this creates
a tendency for labor supply to fall (interest rate effect).
Figure 3.9, Panel (b), shows the change in material consumption, cg,h,t , over the
respective lifetime for each generation g = −14, . . . , 20 of household type h = 1
in the fast aging region. Recall from Panel (a) that the gap between autarky and
trade factor prices increases during the demographic transition and diminishes even-
tually as the working-age population ratios in both region converge. For generations
born prior to year zero, we see that old-age consumption is slightly increased due
to a positive wealth and substitution effect. Consumption in earlier periods is al-
most unchanged because the drop in wage rates and hence negative wage effects
are relatively small. For subsequent generations, i.e. moving along the x-axis from
the left to the right in Panel (b), losses in wage income become increasingly sub-
stantial and lead to larger and larger reductions of consumption in earlier periods of
the life cycle. At the same time, the interest rate gap widens which strengthens the
positive income and intertemporal substitution effect causing increases in old-age
consumption. However, as the extent of real factor price changes over the lifetime
of a generation becomes less favorable, losses in wage income cannot be compen-
sated for by the positive income effect and hence there is a downward adjustment
in consumption for all periods of the life cycle (g ≥ 16). From year 17 onwards, the
trade-autarky differentials in factor prices begin to diminish and households born
during this period experience smaller and smaller decreases in wage rates over their
lifetime. Hence, moving across generations, the size of reductions in young-age con-
19 For the interpretation of results, we concentrate on the link from price changes to household
quantity decision, and neglect the fact that in general equilibrium prices and quantities are deter-
mined simultaneously.
sumption diminishes. Consumption changes across generations for different house-

hold types are very similar (not shown).
Figure 3.9, Panel (c), shows the impact on labor supply, ωg,t − `g,h,t , over the
respective lifetime for each generation g = −14, . . . , 14 of household type h = 1 in
the fast aging region. Generations born prior to the demographic shocks, leave labor
supply largely unchanged as real wages in early stages of the life cycle when labor
productivity is high are almost unchanged. At the same time, they benefit in older
ages from higher interest rates on their savings and therefore adjust labor supply
downwards in later periods of their life cycle. As the wage and interest rate gaps
between trade and autarky situations broaden, decreases in labor supply become in-
creasingly substantial for generations when moving, both, over the life cycle of a
given generation as well as across generations. There are relatively large drops in la-
bor supply for generations g = 0 and g = 2 which belong—looking at the respective
welfare changes in Figure 3.7—to the biggest winners of trade liberalization. Albeit
decreases in real wages during younger ages, the positive wealth effect is strong
enough to make these households significantly better off. For subsequent genera-
tions g ≥ 4, factor price changes over their respective lifetime become increasingly
less favorable implying—for a given age—a decrease in periodic labor supply that
is smaller as compared to preceding generations. This is necessary to prevent an
otherwise too substantial decline in lifetime income.
Figure 3.9, Panel (d), reminds us that labor supply responses are complex deci-
sions that critically depend on the interplay of socio-economic characteristics. Un-
like low-skilled workers of type h = 1, households with middle and high labor pro-
ductivity increase old-age labor supply (here shown for h = 6). In response to the
fall in wage rates, and due to high labor productivity even in older ages, these house-
holds find it optimally to devote a smaller fraction of time to leisure consumption as
compared to autarky.
1. International trade constitutes a “mechanism” which arbitrages away regional
demographic differences thereby mitigating the pressure on real factor prices that
is exerted by demographic change in a closed economy. Hence, in the fast aging
region, the real capital rental increases and the real wage rate decreases relative
to autarky.
2. Gains from trade in the presence of globally unsynchronized aging patterns are
not guaranteed. This is a result of the different evolution of real factor price
changes during the demographic transition. For the fast aging region:
• trade liberalization is only beneficial for current old generations that are born
before and in the beginning of the demographic transition. Future generations
of all household types stand to incur substantial utility losses.
• the intragenerational distribution of welfare gains and losses depends on the
level of labor productivity and the propensity to save throughout the life cy-
cle. “Poor” households, i.e. low-skilled and asset-poor households, tend to be
relatively worse off.
0,10
0,05
Change in SWF (in %)

0,00
-0,05
η=1
η = 0.8
-0,10
η = 0.6
η = 0.4
-0,15 η = 0.2
-0,20
0% 2% 4% 6% 8% 10% 12% 14%
Social discount rate
Fig. 3.10 Sensitivity of social welfare changes to inequality parameter
Note: Change in the social welfare as defined in (3.21) comparing trade with autarky for different
values of ρe and Σ (fast aging region). A low value of ρe on the x-axis implies a high weight on
the utility of future generations. If η = 1, a more utilitarian approach is adopted, whereas smaller
values of η mean that a greater weight is placed on equity.
3.4.4 Aggregate Social Welfare
In this section, we take a first stab on whether trade liberalization in a world which
is characterized by differential population dynamics is desirable from a social stand-
point. We apply a very direct social welfare function approach and specifically as-
sume that aggregate welfare can be measured as:
!1/η
SWFr = ∑ Θr,g,h uηr,g,h (3.21)
g,h
where Σ = 1/(1 − η) is an index of the elasticity of substitution across welfare

change for different agents, and Θr,g,h is a weighting factor which accounts for dis-
counting and population:
Θr,g,h = ωr,g (1 − ρe)g . (3.22)
In this expression, ωr,g is the number of households represented by the generation
and household type, and ρe is the social discount rate which determines the relative
contribution of future generations to aggregate social welfare. When ρe is smaller,
future generations play a larger role in defining social welfare and vice versa. Social
welfare is also influenced by the interhousehold substitution elasticity Σ which cap-
tures trade-offs in welfare for different types and households born at different times.
The critical weakness of the concept of a social welfare function is the more or
less arbitrary choice on how to trade off utility between current and future genera-
tions. Figure 3.10 therefore shows the sensitivity of aggregate welfare changes in
the fast aging region with respect to the social discount rate and the interhousehold
substitution elasticity. A clear picture emerges: trade liberalization in the presence
of globally unsynchronized aging patterns is only beneficial for unrealistically high
social discount rates of about 8% and greater.20
Another perspective on the social desirability of trade liberalization in a world of
global demographic change can be provided by conducting an “hypothetical demo-
cratic referendum”. As in a stylized one-person, one-vote Western democracy, we
assume that each generation and household type alive at a given point in time can
dispense one vote which carries equal weight. A vote for trade liberalization is taken
if the change in the Hicksian equivalent variation is positive; otherwise, people
vote against it. In such a referendum, trade liberalization would almost surely be
voted down—except for the first periods of the demographic transition (up to year
6) where current old generations who benefit from trade are alive. fThe political
outcome of this thought experiment, however, is quite stark: although trade liber-
alization has been shown not to be beneficial from a social perspective, prevailing
political preferences at the beginning of the demographic transition would support
a liberal stance of trade policy at the expense of future generations.21
1. From a social standpoint, trade liberalization for the fast aging region in the pres-
ence of globally unsynchronized aging patterns is only beneficial for a range of
unrealistically high social discount rates.
2. Although not beneficial from a social perspective, the political assessment of
trade liberalization by means of an “hypothetical democratic referendum” under-
taken at the beginning of the demographic transition, would support a liberal
stance of trade policy at the expense of future generations.
3.4.5 Sensitivity Analysis
3.4.5.1 Piecemeal Analysis
In order to explore the robustness of the results with respect to key model parame-
ters, and to develop a better understanding of the impact of each single parameter
in the model, we first conduct a number of “piecemeal” sensitivity analyses. Table
3.2 shows results from variations in either δ , εi , i = 1, 2, or εa while holding all
other parameters constant. The figures in the table refer to percentage deviations of
20 As a first approximation, it seems reasonable to use the market interest rate for discounting social
investments, thereby respecting private preferences. Also, it is often argued that policy makers are
more patient than private citizens, therefore suggesting a social discount rate below the interest rate
(Caplin and Leahy, 2004).
21 Of course, there is a time inconsistency problem here. Future generations want current old
generation not to liberalize trade, yet if international goods markets were to remain separated, they
themselves would vote for trade liberalization.
Table 3.2 Sensitivity of per capita variables under autarky
Parameter Value ∆ capital ∆ output ∆ investment ∆ consum.

(in %) (in %) (in %) (in %)
0.1 6.07 2.99 -11.61 9.25
0.3 1.64 0.82 -4.72 4.50
δ 0.5 0.81 0.40 -3.07 3.06
0.7 0.50 0.25 -2.29 2.33
1.0 0.29 0.15 -1.68 1.72
0.5 4.89 2.39 -12.61 8.82
0.8 5.70 2.80 -11.93 9.11
1.5 6.69 3.31 -11.61 9.48
σY,i , i = 1, 2 1 6.07 2.99 -11.09 9.25
2 7.09 3.51 -10.76 9.63
3 7.55 3.75 -10.38 9.80
5 7.98 3.97 -10.02 9.97
0.5 5.90 2.91 -11.75 9.19
0.8 6.01 2.96 -11.66 9.22
1.5 6.22 3.07 -11.49 9.30
σA 1 6.07 2.99 -11.61 9.25
2 6.35 3.13 -11.38 9.35
3 6.58 3.25 -11.19 9.44
5 6.92 3.43 -10.90 9.56
Note: The table shows results from “piecemeal” sensitivity analysis with respect to δ , εi , i = 1, 2,
and εa (only one parameter is changed while the others are being held constant). The figures refer to
deviations of steady state values of per capita variables in response to population aging as specified
in Section 3.3. All figures refer to the fast aging region. For the “piecemeal” sensitivity analysis all
household parameters are held constant.
steady state values in response to population aging in the fast aging region under the
autarky case. Varying key technology parameters confirms that the results arising
from solving the model with the base case parametrization are qualitatively robust.
In all cases, macroeconomic variables move in same directions. The intensity of eco-
nomic adjustment in response to the demographic shocks is the smaller the higher
is δ , and the lower are σY,i and σA . Intuitively, a higher rate of depreciation leads to
less capital accumulation. A higher elasticity of substitution between capital and la-
bor means that it is possible to increasingly substitute away from costly labor inputs
to capital services which have become relatively cheap due to the capital deepening.
This implies lower costs of production which in turn translate into smaller reductions
in investment, a higher capital stock, and stronger (positive) reactions of output and
consumption. Similarly, a higher substitutability between sectoral goods means that
the price of the final good A decreases as input costs decline due to a shift towards
the less expensive capital-intensive commodity. Furthermore, the piecemeal sensi-
tivity analysis reveals that the ranking in terms of the quantitative effects as shown
in Table 3.2 is also maintained during the transition phase (not shown).
0 ,0 6
0 ,0 5
0 ,0 4
D e n s ity
0 ,0 3
0 ,0 2
0 ,0 1
0 ,0 0
0 2 4 6 8 1 0 1 2 1 4 1 6
D e v ia tio n fr o m in itia l s te a d y s ta te ( in % )
Fig. 3.11 Sample frequency distribution of per capita capital stock
Note: Sample frequency distribution of the percentage deviation of the per capita steady state capi-
tal stock from the initial steady state under autarky (fast aging region). In the systematic sensitivity
analysis, we execute 1,000 simulations of the autarky model drawing key household and technol-
ogy parameters from uniform probability distributions.
3.4.5.2 Systematic Sensitivity Analysis
In order to get a comprehensive picture of what drives the results, and to allow for
the interaction of all parameters in the model, we conduct a systematic sensitivity
analysis and execute 1,000 simulations of, both, the autarky and trade model. In
each simulation, values for the key parameters are drawn from uniform probability
distributions. The support for the distribution of each parameter is chosen so as to
cover a range of empirically plausible parameter values that is well-supported by
the literature; we mainly draw on Backus et al. (1992) and Ambler et al. (2002).22
Figure 3.11 plots the sample frequency distribution of the percentage deviation of
the per capita steady state capital stock from the initial steady state under autarky
(fast aging region). The main message arising from this graph is that population
aging in this economy unambiguously leads to a positive impact on the per capita
capital stock. The sample mean of this distribution is an increase of 4.15%. There is
a 83.5% chance that the increase in the per capital capital stock is smaller than 7%.
Similarly, we perform a systematic sensitivity analysis to check for the sensitiv-
ity of welfare gains and losses from trade liberalization in the presence of globally
unsynchronized aging patterns (Figure 3.12). To compute the “overall’ sample fre-
22 The lower and upper bounds for the uniform probability distributions of each respective parame-
ter are: 0.5 < εi < 5, 0.5 < εa < 5, 0.1 < δ < 1, 0.5 < αh < 0.9, 0.25 < σh < 1.5, 0.25 < σcl,h < 1.5.
In all simulations, labor productivity is parameterized as in the base case scenario.
quency distribution of changes in Hicksian equivalent variation, we pool welfare

estimates across all different household types and age-groups that are alive during
the economic transition period (up to t = 55). The sample comprises in total 710, 000
households which differ with respect to their age, i.e. the point in life when they are
affected by demographic shocks, labor productivity, and other key behavioral pa-
rameters that govern the intra- and intertemporal behavior.23 The resulting sample
distribution is roughly symmetric and its sample mean is a decrease in EV equal
to −0.24%. This compares roughly with what one could expect from loose visual
inspection of Figure 3.7. The sample variance is 1.3. Based on the sample distri-
bution, there is a 80.7% probability that welfare gains are negative. The analysis
therefore unequivocally demonstrates that, unlike classical trade theory would sug-
gest, trade liberalization in the presence of globally unsynchronized aging patterns—
other things being equal—bears a high risk of negative welfare effects for house-
holds in the relatively fast aging region.
3.4.5.3 Uniqueness of Equilibria
A major concern of the sensitivity analysis was to check for the potential existence
of multiple equilibria. Galor (1992) pointed out the possibility of global indetermi-
nacy of the perfect-foresight equilibrium in the two-sector neoclassical OLG model.
In principle, this contingency cannot be ruled out by the specific structure and as-
sumptions of the model. The non-existence of a closed form solution makes it im-
possible to analytically characterize the dynamical system and establish conditions
for uniqueness. Results from the previous sensitivity analyses, however, suggest that
changes in key parameters of the model do not lead to qualitative reversals. More-
over, varying parameter values alters equilibrium outcomes of endogenous variables
in a ’monotonic way’. Finally, we experimented with the choice of T . Kehoe and
Levine (1985) have shown that in the OLG framework indeterminacy would mani-
fest itself as sensitivity to the truncation date. None of the models presented here are
sensitive to T , provided that it is sufficiently large. We interpret all these findings as
evidence that the equilibria are unique.
Despite the fact that the existing literature has consistently identified globally un-
synchronized aging patterns to be a potentially important driving force of cross-
border flows of capital and labor, the implications for the international exchange
of goods have been largely overlooked. This chapter fills the gap and develops a
numerical dynamic general equilibrium framework that combines elements of the
factor-proportions theory of international trade with those of Auerbach and Kot-
23 Running 1,000 simulations of the trade model drawing key parameters from uniform probability
distributions takes approximately six days on a dual core 2 GHz computer.
0 ,8
0 ,7
0 ,6
0 ,5
D e n s ity
0 ,4
0 ,3
0 ,2
0 ,1
0 ,0
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4
C h a n g e in H ic k s ia n E V ( in % )
Fig. 3.12 Sample frequency distribution of welfare gains from trade liberalization
Note: Sample frequency distribution of the percentage change in Hicksian equivalent welfare com-
paring trade with autarky in the presence of globally unsynchronized aging patterns (fast aging
region). In the systematic sensitivity analysis, we execute 1,000 simulations of the autarky and
trade model drawing key household and technology parameters from uniform probability distri-
butions. The sample comprises in total 710, 000 households that are alive during the economic
transition phase and which differ with respect to their age, i.e. the point in life they are affected by
demographic shocks, and labor productivity and other key behavioral parameters that govern the
intra- and intertemporal behavior.
likoff (1987)-type OLG models to analyze the economic consequences of trade lib-
eralization in the presence of global demographic change.
We demonstrate that demographics emerge as a potential determinant of inter-
national trade flows. To the extent that age-dependent savings and labor supply
decisions by households have an impact on the aggregate capital stock and labor
force, population aging alters the relative abundance of factors of production and
thereby—in the presence of globally unsynchronized aging processes—gives rise to
Heckscher-Ohlin trade patterns. International trade can be viewed as a “mechanism”
which potentially arbitrages away regional demographic differences, and thereby
mitigates the pressure on real wages and interest rates that is created by population
aging in a closed economy.
Moreover, we provide a detailed analysis of the inter- and intragenerational dis-
tribution of gains from trade. In contrast to what one would expect from standard
neoclassical trade theory, gains from trade under regional unsynchronized aging
patterns are not guaranteed. Who gains from trade liberalization depends on their
specific set of socio-economic characteristics. We find, for instance, that in the fast
aging region current old generations born before and in the beginning of the de-
mographic transition benefit whereas future generations stand to incur substantial
utility losses. The intragenerational distribution of welfare gains and losses depend
on the level of labor productivity and the propensity to save throughout the life cycle.
Low-skilled workers and asset-poor households tend to be relatively worse off. On
a regional level, gains from trade for the fast aging region require implausibly high
social discount rates. The results are robust over a broad range of empirically plausi-
ble parameter configurations. We perform a systematic sensitivity analysis and find
that there is 80.7% probability that households in the fast aging region do not gain
from trade.
Of course, the results obtained are subject to several caveats which may also
serve as suggestions for future research. First, by focussing on the goods market
channel as the only linkage between countries, the critical assumption is made that
factors of production are internationally immobile. Integrating cross-border migra-
tion and international capital flows into the model would add an additional mecha-
nism to arbitrage away regional differences in observed population dynamics. Other
factors being equal, this would most likely reduce the magnitudes of adjustment re-
sponses of economies including a lower level of interregional goods flows and less
pronounced changes in households’ welfare.
Second, the model abstracts from any government activity and in particular does
not consider a public sector pension system. As pointed out above, recent studies
emphasize the role of a public pension system in determining households’ savings
behavior. The model takes an extreme standpoint on this issue by assuming the
presence of a fully-funded pension system which implicitly operates through private
life-cycle savings decisions of households.
Third, in reality there are numerous obstacles preventing international goods mar-
kets from being fully integrated. As long as barriers to trade exert a symmetrical ef-
fect on both regions, the qualitative implications of the analysis should be preserved.
However, cross-country differences in the active set of trade policy instruments are
likely to result in an asymmetric distribution of gains and losses from trade.
Fourth, and probably most critical, is the fact that we carry out the analysis in an
idealized neoclassical world. For instance, introducing elements of imperfect com-
petition, increasing returns to scale and making different assumptions about labor
markets are needed to enhance the policy relevance of the simulation experiments.
Also, it has been shown that if the basic dichotomy of the Heckscher-Ohlin frame-
work is extended to account for multiple skill-related categories of workers (Wood,
1994), country groups (Davis, 1996) and traded goods (Feenstra and Hanson, 1996),
then the main distributive prediction of the Heckscher-Ohlin theory is theoretically
undetermined. Whether the inclusion of those factors would materially alter the con-
clusions is a question for future research.
Appendix: Numerical Simulation of the Model
This appendix provides a sketch of the major issues involved in numerical simula-
tion of the model. In particular, we (i) briefly explain the calibration to a steady
state, (ii) provide an overview of the adopted solution algorithm, and (iii) fully char-
acterize the general equilibrium of the numerical model in a mixed-complementarity
format.
3.5.1 Steady State Calibration
We use the calibration procedure for OLG models which is described in detail in
Rasmussen and Rutherford (2004). The OLG economy is calibrated to an initial
steady state equilibrium in which all quantities grow with constant rate 1 + γ̄ and
present value prices decline with the interest rate 1 + r. The virtue of this approach
is that the calibration of the OLG demand system is independent from the specific
model structure of the production side. The calibration procedure is carried out in
two steps. Demographic shocks are imposed as a counterfactual scenario and are
not incorporated in the initial steady state calibration procedure.
The first step solves for the optimal behavior of a single reference generation
taking into account the existence of aggregate consistency conditions which ensure
that individual choices by OLG households match the aggregate behavior of the
economy. Since in a steady state we know the full path of present value prices, op-
timal behavior for all generations (and household types) can be inferred from the
optimal behavior of a single generation. We pose the household calibration model
as a mixed-complementarity problem (MCP) allowing for corner solutions in labor
supply (we indicate the associated complementary variable to each equilibrium con-
dition using the “perp” operator, “⊥”). Table A–3.3 defines all model variables and
parameters. For generation g = 0, the solution to the household utility maximization
problem given by (3.2) is fully characterized by the following system of equations
(3.23) – (3.35) (since both regions share the same steady state equilibrium, the re-
gion index is dropped):
Definition of full consumption:
νh 1/νh

νh
za,h = αh ca,h + (1 − αh ) à,h ⊥ za,h (3.23)
FOCs for material consumption:
∂U(ca,h , à,h , ρ)
= λh p̄a ⊥ ca,h (3.24)
∂ ca,h
FOCs for leisure:

∂U(ca,h , à,h , ρ)
= ηh ⊥ à,h (3.25)
∂ à,h
FOCs for price of labor time:
ηh = λh p̄a πa,h ⊥ la,h (3.26)
FOCs for price of lifetime income:
∑ p̄a ca,h = ∑ p̄a πa,h la,h ⊥ λh (3.27)

a a
FOCs for price of time:
ωscale = à,h + la,h ⊥ ηh (3.28)
Price index for full consumption:

1/(1−σν )
h
σνh 1−σνh σνh ηa,h 1−σνh
pza,h = αh p̄a + (1 − αh ) ( ) ⊥ pza,h (3.29)
λh
Present value assets over the life cycle:

a
caa,h = ∑ p̄a0 (πa0 ,h la0 ,h − ca0 ,h ) ⊥ caa,h (3.30)
0
a =0
Value of assets held by age:

p¯a
cmaa,h = caa,h ⊥ cmaa,h (3.31)
(1 + γ̄)a
Aggregate consumption:
ca,h
ccch = ∑ ⊥ ccch (3.32)
a (1 + γ̄)a
Aggregate assets:
ccmah = ∑ cmaa,h ⊥ ccmah (3.33)
a
To fix aggregate consumption at the benchmark value select ρ such that:
∑ ccch = C̄ ⊥ ρ (3.34)
h
To fix aggregate assets at the benchmark value select ωscale such that:
∑ ccmah = (1 + r̄) K̄ ⊥ ωscale . (3.35)

h
To calibrate the model to the benchmark values of aggregate consumption and ag-
gregate assets, we add two additional constraints to the household problem and en-
dogenize the discount factor and a scaling factor on the periodic time endowment.
In the second calibration step, the results from the household calibration model
are used to set up the entire baseline path for all time periods and including those
generations that were born prior to year zero. This involves extrapolating the optimal
behavior of the reference generation (including all different household types) by
making use of the steady-state assumption.
3.5.2 Solution Algorithm
To solve the OLG economy that has been formulated in section 3.2, we use a de-
composition algorithm which has been described in Chapter 2. In what follows, we
provide a brief description of how the algorithm can be applied in the present context
of a two-country, two-sector OLG model. Each iteration of the algorithm comprises
the following steps:
1. Obtain the general equilibrium prices of the “related” Ramsey growth problem.
The “related” Ramsey growth problem is characterized by a model in which the
demand system of OLG households has been replaced by a single representative
infinitely-lived agent. In this model, all other structural elements are identical to
those in the underlying OLG economy.
2. Given general equilibrium prices from the representative agent model, evaluate
OLG households’ demand functions. This step retains the full structure of the
OLG demand system but suppresses any general equilibrium feedback effects.
3. Use the quantity choices from the partial equilibrium relaxation, to recalibrate
the preferences of the representative agent.
4. Return to Step 1 and repeat the procedure until the algorithm converges.
3.5.2.1 Equilibrium in Mixed-Complementarity Format
We now formulate the equilibrium of the “related” Ramsey optimal growth model
as a mixed-complementarity problem. The structure of equilibrium is exploited by
the GAMS program and the solver we use to compute the transition and steady state
of the infinite-horizon economy.24 Rutherford (1995b) and Mathiesen (1985) have
shown that a complementary-based approach is convenient, robust, and efficient. A
characteristic of economic models is that they naturally involve a complementary
problem, i.e. given a function F: Rn −→ Rn , find z ∈ Rn such that F(z) ≥ 0, z ≥ 0,
and zT F(z) = 0. A fundamental advantage of formulating an economic model as a
24 For an overview of applied general equilibrium modeling with GAMS (General Algebraic
Modeling System) and the GAMS/MPSGE subsystem see e.g. Rutherford [1998,1999a], and
http://www.mpsge.org.
complementary problem is the ability to express weak inequalities and complemen-

tary slackness.
An equilibrium in complementarity format can be posed as a system of three
classes of nonlinear inequalities in three sets of economic variables: commodity and
factor prices, activity levels, and income levels.
1. The first class of equilibrium conditions are zero profit conditions which state
that all production activities earn zero excess profit in equilibrium. Zero-profit
condition exhibit complementary slackness with respect to the associated activity
level.
2. The second class of equilibrium conditions are market clearance conditions. They
state that supply must be greater than or equal to demand for each primary factor
and produced good. Market clearance conditions exhibit complementary slack-
ness with respect to market prices.
3. The third class of equilibrium conditions are income balance equations that state
that a household’s expenditure must not exceed his income.
Note that complementary slackness is a feature of the equilibrium allocation even
though it is not imposed as an equilibrium condition, per se (Rutherford, 1995b).
This means that in equilibrium, any production activity which is operated makes
zero profit and any production activity which earns a negative net return is idle.
Likewise, any commodity which commands a positive price has a balance between
aggregate supply and demand, and any commodity in excess supply has an equilib-
rium price of zero.
Consequently, the “related” Ramsey optimal growth problem of the underlying
OLG economy is fully characterized by the system of equations (3.36) – (3.53).
Table A–3.4 defines all variables and parameters. We indicate the associated com-
plementary variable to each equilibrium condition using the “perp” operator, “⊥”):
zero profit for sector i:
εi /(εi −1) 1−1/εi

1/(1−εi ) εi /(εi −1)
αi pr,l,t + (1 − αi )1/(1−εi ) pr,re,t = pi,t ⊥ Yi,r,t (3.36)
zero profit for final goods sector:
ε /(ε −1) 1−1/εa

1/(1−εa ) εa /(εa −1)
αa p1,t + (1 − αa )1/(1−εa ) p2,ta a = pr,a,t ⊥ Ar,t (3.37)
zero profit for capital accumulation:
for t = 0, . . . , T − 1 : pr,k,t = pr,re,t (1 − τr,t ) + pr,k,t+1 (1 − δ ) ⊥ Kr,t (3.38a)
for t = T : pr,k,t = pr,re,t (1 − τr,t ) + pktr (1 − δ ) ⊥ Kr,t (3.38b)

zero profit for investment:
for t = 0, . . . , T − 1 : pr,a,t = pr,k,t+1 (1 + τr,t ) ⊥ Ir,t (3.39a)

for t = T : pr,a,t = pktr ⊥ Ir,t (3.39b)

zero profit for material consumption:
pr,a,t = pr,c,t (1 + τr,t ) ⊥ Cr,t (3.40)
zero profit for full consumption:
ν/(ν−1) 1−1/ν

1/(1−ν) ν/(ν−1)
Λr,t pr,c,t + (1 − Λr,t )1/(1−ν) pr,l,t = pr,z,t ⊥ Zr,t (3.41)
zero profit for utility:

T
Θ
∏ pr,z,tr,t = pr,u ⊥ Ur (3.42)
t=0
market clearance for sector i output:
∂ pr,a,t
∑ Yi,r,t = ∑ Ar,t ⊥ pi,t (3.43)
r r ∂ pi,t
market clearance for consumption:
∂ pr,z,t
∑ Cr,t = Zr,t ∂ pr,c,t (1 + τr,t ) ⊥ pr,c,t (3.44)
r
market clearance for final output:
Ar,t = Ir,t +Cr,t ⊥ pr,a,t (3.45)
market clearance for capital services:
∂ pi,t
Kr,t (1 − τr,t ) = ∑ Yi,r,t ⊥ pr,re,t (3.46)
i ∂ pr,re,t
market clearance for labor services:
∂ pi,t
Lr,t = ∑ Yi,r,t ⊥ pr,l,t (3.47)
i ∂ pr,l,t
market clearance for capital stock:
for t = 0 : ∑ kr,g,h,g = Kr,t ⊥ pr,k,t (3.48a)

g,h
for t = 0, . . . , T − 1 : Kr,t−1 (1 − δ ) + Ir,t−1 = Kr,t ⊥ pr,k,t (3.48b)

for t = T : Kr,t (1 − δ ) + Ir,t = T Kr ⊥ pktr (3.48c)
market clearance for utility:
pr,u Ur = incr ⊥ pr,u (3.49)
market clearance for full consumption:
pr,z,t Zr,t = pr,u Ur ⊥ pr,z,t (3.50)
income definition:
T
incr = ∑ pr,l,t Ωr,t + pr,k,0 ∑ kr,g,g + T Kr pktr ⊥ incr (3.51)
t=0 g
constraint for current account premium:

pr,l,t Ωr,t + pr,re,t Kr,t = pr,k,t Ir,t + pr,c,t Cr,t (1 − τr,t ) ⊥ τr,t (3.52)
constraint for post-terminal capital stock:
Ir,T /Ir,T −1 = Yr,T /Yr,T −1 ⊥ T Kr . (3.53)
T denotes the last period of the numerical model. To approximate the underlying infi-
nite horizon economy by a finite-dimensional complementarity problem we choose
a “state variable targetting” approach as proposed by Lau et al. (2002). The infinite
horizon economy can be decomposed into two distinct problems where one runs
from 0, ... , T and the other one runs from T + 1, . . . , ∞.25 Both subproblems are
linked through the post-terminal capital stock in period T + 1. The level of post-
terminal capital is computed endogenously by requiring that investment grows at
the same rate as sectoral output or any other “stable” quantity in the model (see
(3.53)).
The current account premium, τr,t , adjusts to satisfy the additional constraint
(3.52) which ensures that trade is balanced in each period.
The share parameters Λr,t and Θr,t are initially chosen in a way such that the “re-
lated” Ramsey optimal growth problem displays the same baseline steady state path
as the underlying OLG economy. Ωr,t denotes the time endowment of the represen-
tative agent which is a productivity-adjusted sum of the time endowments of OLG
households.
3.5.2.2 Partial Equilibrium Relaxation of the Underlying OLG Economy
Let p denote the price vector of equilibrium prices that are obtained from solving
the “related” Ramsey optimal growth problem from the previous step. Given the
CES preferences of OLG households, it is possible to obtain from the optimization
problem in (3.2) closed-form demand functions for all generations and all household
types:
25 Note that this method for approximating the infinite horizon relies on the assumption of time-
separable utility functions.

Table 3.3 List of variables and parameters (household calibration model)
Variable Definition
ca,h Material consumption by household type h at age a
à,h Leisure consumption by household type h at age a
za,h Full consumption (composite of leisure and material consumption)
λh Shadow price of lifetime income of household type h
ηh Shadow price of time of household type h
la,h Labor supply by household type h at age a
ωscale Scaling factor on time endowment (parameter used for calibration)
pza,h Price of full consumption for household type h at age a
caa,h Present value of assets over the life cycle for household type h at age a
cmaa,h Value of assets held by age and household type
ccch Total consumption by households of type h
ccmah Total value of assets by households of type h
ρ Discount factor (parameter used for calibration)
Parameter Definition
r̄ Steady state interest rate
γ̄ Steady state population growth rate
p¯a = (1 + r̄)−a Steady state index of present value prices
αh Weight on material consumption for household of type h
σh Intertemporal elasticity of substitution for household of type h
σcl,h Intratemporal elasticity of substitution for household of type h
πa,h Index of labor productivity for household type h at age a
K̄ Benchmark value of capital stock
C̄ Benchmark value of aggregate consumption
x = D (Ψ , p) (3.54)
where x represents a generic variable representing cr,g,h,t and `r,g,h,t , and Ψ denotes
relevant household parameters. Note that evaluating x at p is equivalent to solving a
partial equilibrium relaxation of the underlying OLG economy in which all general
equilibrium interactions due to quantity adjustments are suppressed.
3.5.2.3 Recalibration of Preferences of the Representative Agent Model
The last step of each iteration involves updating share parameters Λr,t and Θr,t ac-
cording to:
pr,c,t ∑tg=t−N ∑H
h=1 cr,g,h,t
Λr,t = t H
(3.55)
∑g=t−N ∑h=1 pr,c,t cr,g,h,t + pr,l,t `r,g,h,t
∑tg=t−N ∑H
h=1 pr,c,t cr,g,h,t + pr,l,t `r,g,h,t
Θr,t = (3.56)
∑t=0 ∑g=t−N ∑H
T t

h=1 pr,c,t cr,g,h,t + pr,l,t `r,g,h,t
Table 3.4 List of variables and parameters (“related” Ramsey optimal growth problem)
Variable Definition
Ur Utility for representative agent in region r
incr Lifetime income of representative agent in region r
Yi,r,t Output of sector i in region r at time t
Ar,t Final good (CES aggregate of tradable Y ’s) in region r at time t
Zr,t Full consumption (material consumption + leisure) in region r at time t
Ir,t Aggregate investment demand in region r at time t
Kr,t Aggregate capital stock in region r at time t
T Kr Aggregate post-terminal capital stock in region r
Cr,t Aggregate consumption demand in region r at time t
pr,a,t Price of final good at time t in region r
pr,c,t Price of consumption at time t in region r
pi,t Price of tradable sectoral output i at time t
pr,u Price of a unit of utility for representative agent in region r
pr,l,t Market wage rate at time t in region r
pr,z,t Price of full consumption at time t in region r
pr,re,t Capital rental rate at time t in region r
pr,k,t Price of capital at time t in region r
pktr Post-terminal price of capital in region r
τr,t Current account premium at time t in region r
Parameter Definition
Λr,t Weight on material consumption
Θr,t Weight on periodic full consumption in intertemporal utility
αi Capital share parameter in sector i
αa Share parameter in production of A
ν Elasticity parameter (material consumption vs. leisure)
εi Elasticity parameter in sector i production (capital vs. labor)
εa Elasticity parameter in production of A (commodity i vs. j)
δ Periodic capital depreciation rate
Ωr,t Aggregate time endowment at time t in region r
where prices represent general equilibrium prices from Step 1 and quantities repre-
sent partial equilibrium choices obtained under Step 2. Similarly, the time endow-
ment of the representative agent, Ωr,t , is updated in each iteration. Subsequently, the
algorithm involves re-solving the “related” Ramsey optimal growth problem which
is given by (3.36)–(3.53) using the updated values for Λ and Θr,t .
Chapter 4
Quantifying the Sectoral and Distributional
Effects of Demographic Change in Germany
4.1 Introduction
The accelerating pace of the demographic transition in Germany will prove to be

one of the key factors in the development of society in the coming decades. This
process is driven by falling mortality rates and a decline in birth rates, which reduces
population growth rates and increases the share of older people in the economy.
Figure 4.1, based on demographic projections by the Federal Statistical Office of
Germany, illustrates the impact of population aging on the population growth rate,
defined here as the growth rate of the adult population, and the ratio of the working-
age population (aged 20-64) to total population (20-94) for the period 2003-2050.
Population growth rates are predicted to decline and will even turn negative in 2014.
As a consequence, the population starts shrinking in around 2017 (not shown). The
working-age population ratio, as a crucial indicator of aging, is projected to decrease
sharply by 13.8% from 0.74 in 2003 to 0.62 in 2050.
A considerable amount of the economic literature has scrutinized many aspects
of how the demographic transition is going to affect future economic activity. This
chapter focuses on two issues that have received surprisingly little attention. The
first objective of this chapter is to quantify the impact of demographic change on
the sectoral composition of output. In the model, the sectoral adjustment to demo-
graphic change rests on two key mechanisms. First, as technological differences
across sectors generally imply that firms operate at different factor intensities, the
increase in the aggregate capital-labor ratio that arises from population aging is ab-
sorbed differently across sectors. Sectors that employ abundant capital and attract
scarce labor most efficiently will grow faster than the rest of the economy, while
other sectors will contract due to the demographic transition. Differing costs of pro-
duction also imply that relative goods prices change with ensuing general equilib-
rium consequences. Second, as the composition of household consumption varies
with age (see Federal Statistical Office of Germany (2003) for empirical evidence
for Germany, and Börsch-Supan (2003) for a discussion) changes in the population
structure induce a demand-side driven effect that can potentially give rise to sec-

82 4 Quantifying the Sectoral and Distributional Effects of Demographic Change in Germany
0 ,7 6 0 ,0 0 4
0 ,7 4
w a p r
p o p g ra te 0 ,0 0 2
w o r k in g - a g e p o p u la tio n r a tio
0 ,7 2
p o p u la tio n g r o w th r a te
0 ,0 0 0
0 ,7 0
0 ,6 8 -0 ,0 0 2
0 ,6 6
-0 ,0 0 4
0 ,6 4
-0 ,0 0 6
0 ,6 2
0 ,6 0 -0 ,0 0 8
2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0
Y e a r
Fig. 4.1 Evolution of working-age population ratio and population growth rate
Note: Own calculations based on demographic projections by the Federal Statistical Office of Ger-
many, Eleventh Coordinated Population Forecast 2005, Variant 1-W2. The working-age population
ratio is here defined as the population aged 20-64 as a fraction of total adult population (aged 20-
94). Population growth rates refer to the growth rate of the adult population.
toral adjustments as well. Consequently, and in contrast to the existing literature,

a proper quantitative assessment of the transitional-dynamic impact of population
aging requires to go beyond the standard macroeconomic single-commodity world.
The second objective of this chapter is to quantify the distributional and welfare
consequences of the demographic transition in Germany. As labor is expected to
be scarce relative to capital, real wages are bound to increase while real returns to
capital decrease. A priori, it is not clear how the opposite movement of factor prices
will affect households’ labor supply, life cycle savings behavior, and welfare. We
compare the welfare effects along an inter- and intragenerational dimension, and
also assess how the distribution of labor income and wealth evolves over time.
To investigate these issues, we use demographic projections from the Federal
Statistical Office of Germany, together with a large-scale overlapping generations
(OLG) model pioneered by Auerbach and Kotlikoff (1987). We extend the model in
two directions which are both necessary for the questions we want to address. First,
the model features 17 sectors that represent sectoral aggregates of all 71 industries
of the German economy (as distinguished by official Input-Output data). Second,
apart from the heterogeneity of age of households, we enrich the model by allow-
ing for intra-cohort heterogeneity. The model distinguishes eight household types
within each generation that correspond to the eight-income classes according to the
German Income and Expenditure Survey (EVS: Einkommens- und Verbrauchsstich-
probe). Intra-cohort heterogeneity is due to differences in labor productivity and
4.1 Introduction 83
the level of transfer income. Abstracting from this heterogeneity would not allow a
meaningful analysis of the distributional consequences of changes in factor prices.
The results of this chapter are as follows. Over the main projection period from
2003-2050, the demographic transition in Germany will bring about a 7% decrease
in output per capita. This is largely driven by a significant decrease in aggregate la-
bor supply, about 17% over the same horizon (as we model a labor-leisure trade-off
this number already incorporates general equilibrium reactions by households), and
a substantial decline in investment rates (minus 26% in 2050). Population aging is
shown to imply a “capital deepening” process which is reflected by an increase in
the capital-labor ratio of around 2%. As the aging of society shifts the age compo-
sition of the population towards older households that (on average) hold a larger
amount of assets, capital becomes relatively abundant, while labor, also due to the
slower growth in the arrival of new workers, becomes relatively scarce. The higher
capital-labor ratio reduces the need for firms to invest in new physical capital, and
thus investment rates fall. Real factor prices reflect the varying scarcities of factors
of production, and it is projected that the real capital rental rate (real wage rate) falls
(increases) by 0.5% (0.5%) in 2010 and by about 1.3% (1.3%) in 2050.
The demographic transition induces substantial changes in the sectoral composi-
tion of output. Sectoral changes—as measured by a change in the share of sectoral
output in total domestic output—range between about −8.5% and +6.5% in 2010
and between −23.5% and +20.0% in 2050. Expanding sectors are characterized
by higher growth rates of sectoral employment of labor and capital relative to the
economy-wide growth rates of labor and the capital stock. Among the sectors that
benefit most from the demographic transition endowments due to population aging
are Public Services, Textiles and leather products, Education, and Health. Output
shares for the latter two sectors increase by almost one fifth between 2003 and
2050. The sectors that contract most, relatively to total domestic output, are Met-
als, Machinery (around −10%) and Construction, Energy, and Water (−23.51%).
Personal Goods, Mining, and Real Estate Services contract by less (around −2%
to −4%). Output shares for the remaining sectors Mineral and Chemical Products,
Food Products, Printing and Publishing, Wholesale and Retail Trade, Transporta-
tion and Communication, and Banking and Insurance Services change by a rela-
tively small extent (around −1.7% to +1.7%).
Accounting for structural changes in life-cycle consumption that are due to age-
specific preferences does not affect the qualitative results of the benchmark model,
and has only minor quantitative effects for aggregate variables. This underlines that
the nature of the macroeconomic transition is predominantly shaped by the negative
labor supply shock. On the sectoral level, however, demand-side induced effects
stemming from age-dependent consumer spending are found to be quantitatively
important.
In order to evaluate the welfare consequences of the demographic transition we
ask the following question: suppose households of different age and type alive in
2003 were to live through the economic transition with changing factor prices in-
duced by the demographic change. Then how would their welfare change relative
to a situation without a demographic transition ? We find that young households
experience substantial welfare gains because they benefit from a future path of in-
creasing wage rates and do not suffer strongly from large losses of capital income on
already accumulated financial wealth. Newborn households in 2003 obtain welfare
gains in the order of 14% and more in lifetime income. In contrast, older asset-rich
households tend to gain less or even lose because of declining interest rates. From
an intra-generational perspective, we find that those members of society for whom
labor income constitutes a smaller part of (future) resources, i.e. households with
relatively low labor productivity, benefit less from the demographic transition. Wel-
fare changes for households with the highest labor productivity are estimated to
be almost twice as large in terms of equivalent variation in lifetime income as for
the least productive households. This underlies the need to account for intra-cohort
heterogeneity.
The demographic transition is projected to increase income inequality in Ger-
many, indicated by an increase in the Gini coefficient by 8.4%. The growing dis-
persion in household income is driven by a rise in capital income inequality and
overcompensates the projected decrease in labor income inequality. As capital in-
come is proportional to wealth, and because the demographic transition induces a
shift towards older asset-rich households, capital income inequality is bound to in-
crease. Labor income inequality decreases because a future path of increasing wages
implies a flatter labor supply profile over the life cycle. We also find that intergen-
erational factors rather than a redistribution between different types of households
within a particular age group account for the observed evolution of income inequal-
ity.
Despite the economic relevance of sectoral changes as an adjustment mechanism
to demographic change, we are only aware of one example in the literature that ad-
dresses this issue. Fougere, Mercenier and Merette (2007) construct a multi-sectoral
OLG model for the Canadian economy which features, among other factors, seg-
mented labor markets and age-dependent preferences. Their analysis focuses on
labor market effects of population aging that are induced by shifts in the sectoral
composition of output and does not investigate the consequences for welfare and
the distribution of income and wealth. Compared to their model, we include en-
dogenous labor supply, intra-cohort heterogeneity, and also allow for international
borrowing and lending, whereas they require trade to be balanced in each period.
More generally, this chapter relates to the literature that uses models and tech-
niques pioneered by Auerbach and Kotlikoff (1987) to study the economic conse-
quences of population aging. The majority of these studies pays special attention to
the impact of aging on the viability of social security systems in closed economies
(see e.g. Huang et al. (1997), De Nardi et al. (1999), Abel (2003), and Fehr et al.
(2004a) ) or in open economy settings ( Attanasio et al. (2006), Börsch-Supan et al.
(2006)). Relative to the literature we see the contribution of this chapter in (i) taking
into account sectoral adjustments that influence the economy’s transition path (ii) in
evaluating the welfare consequences of population aging per se and not just the alter-
native social security reform scenarios and (iii) in incorporating intra-cohort hetero-
geneity which allows to analyze the distributional consequences of changing factor
prices due to the demographic shifts. A similar type of welfare analysis is carried out
4.2 Model Description 85
by Krueger and Ludwig (2007) in a multi-region model with household heterogene-

ity that, however, also lacks a disaggregated sectoral structure. Furthermore, and in
contrast to the present model that is specifically calibrated to the German economy,
their framework is geared towards studying the implications of population aging for
international capital flows among a number of world regions.
The fact that multi-sectoral OLG models virtually do not appear in the literature
on demographic change—Fougere et al. (2007) being the notable exception—is
partly due to the computational burden that is associated with solving such large-
scale models. Especially for the type of analysis that we pursue in this chapter, the
numerical problem at hand involves a large number of dimensions resulting from
the joint presence of an array of important model features such as realistic lifetime
of agents, heterogeneous households, a multi-sectoral structure, and demographic
dynamics. In order to compute the equilibrium transition path for the model econ-
omy, the decomposition algorithm from Chapter 2 is used. Note that with a conven-
tional integrated solution methods, e.g., as put forward by Rasmussen and Ruther-
ford (2004) for the case of solving OLG models in a complementarity format, this
type of analysis would not be feasible.
The remainder of this chapter is organized as follows. In the next section we
describe and formulate the quantitative model in a mixed-complementarity format.
Section 4.3 discusses the calibration of model parameters and describes the various
data used. Section 4.4 presents results for the benchmark model. In Section 4.5 we
conduct a number of sensitivity analyses to check for the robustness of the results,
including age-specific consumption behavior. Section 4.6 concludes, and separate
appendices contain more information about details of the model formulation and
the adopted computational strategy.
4.2 Model Description
To quantify the economic consequences of the demographic transition for Germany,

we construct an overlapping generations model ad modum the Auerbach and Kot-
likoff (1987) model. The model features 17 sectors and 8 different household types
within each generation. Households have a deterministic lifespan of 74 periods,
hence at each point in time there are 74 × 8 = 592 different household types. We
adopt the small open economy assumption and model international trade according
to the standard assumption that foreign and domestic goods are imperfect substi-
tutes.1 We do not impose any restriction on the balance of payments other than that
the present value of exports must equal the present value of imports over the infinite
horizon, and therefore allow for international borrowing and lending. The analysis
is carried out under the hypothesis of a stylized neoclassical world without market
imperfections and in which agents behave fully rationally. The model is calibrated
using German Input-Output data for the year 2003 and the numerical specification
1 Without this last assumption only the net trade balance would matter and the levels of imports
and exports would be indeterminate.

Hi,t X i,t
σi,HX
Y i,t
σi,Y
VA i,t M i,t
σi,KL σA
K i,t L i,t A1,t A j,t AI,t
Fig. 4.2 Nesting structure of production
of the households side partly draws on data from the 2003 German Income and
Expenditure Survey. Finally, demographic data is taken from the Federal Statistical
Office of Germany and serves as the major exogenous driving process.
4.2.1 Firms
4.2.1.1 Production
Figure 4.2 provides a schematic overview of the nesting structure of sectoral pro-
duction. In each production sector i, j = 1, . . . , I, a representative firm produces a
homogeneous output (Yi,t ). We use a nested constant-elasticity-of-substitution (CES)
production function to reflect empirical evidence on the substitution possibilities. In
the top nest, a material composite (Mi,t ) is combined in fixed proportions with aggre-
gate value added (VAi,t ), i.e. σi,Y = 0, ∀i. M consists of intermediate inputs with fixed
coefficients (Leontief production structure), whereas VAi,t consists of capital (Ki,t )
and labor (Li,t ) services, trading off at a constant elasticity of substitution. Adopting
the calibrated share form (see Appendix 4.6), the unit cost function for each sector i
can be written as2 :
2 There are no explicit production functions in the model because all necessary information is
contained in the dual cost functions.
Ci,t = ΩY,i βiVA CVA,i,t + (1 − βiVA )CM,i,t

(4.1)
with
" 1−σVA,i 1−σVA,i # 1−σ1VA,i
pl,t pr,t
CVA,i,t = βiL + (1 − βiL ) (4.2)
pl,t pr,t
pA, j,t
CM,i,t = ∑ , i 6= j (4.3)
j χj
where CVA,i,t and CM,i,t =cost index of intermediary aggregate VA and M, respec-
tively, ΩY,i =scale parameter, βiVA = benchmark value share of VA in total cost,
βiL =benchmark value share of L in VA aggregate, pl,t =wage rate, pr,t =rental rate
of capital, pA, j,t =price of Armington good j, χ j =fixed quantity of Armington good
j, σVA,i =elasticity of substitution between capital and labor in the VA nest. Variables
with a “bar” superscript denote benchmark values.
4.2.1.2 Factor Demand
Capital and labor are perfectly mobile across sectors. Each individual firm is as-
sumed to be small in relation to its respective sector and operates on perfectly com-
petitive markets taking goods and factor prices as given, and earning zero profits.
Cost minimization yields the following demand functions for primary factors at the
sectoral level (applying Shepard’s Lemma):
pr,t σVA,i

Ki,t = Yi,t CVA,i,t (4.4)
pr,t
pl,t σVA,i

Li,t = Yi,t CVA,i,t . (4.5)
pl,t
Demand for intermediate input j by sector i is given by:
Ai, j,t = Yi,t χ −1

j , i 6= j . (4.6)
4.2.1.3 Capital Accumulation and Investment
The law of motion for the aggregate capital stock is given by:
Kt+1 = (1 − δ ) Kt + It (4.7)
where Kt =aggregate capital stock, It =gross aggregate investment, and δ =periodic

depreciation rate. The associated dual cost functions for producing capital services
are given by:
pk,t = pr,t + pk,t+1 (1 − δ ) (4.8)
where pk,t =purchase price of capital. Investment goods are produced from sectoral
outputs with fixed production coefficients. A unit of the investment good adds to
next period’s capital stock. The investment technology is given by the following
dual cost function: !
I
IA pA,i,t
Ω I ∑ βi ≥ pk,t+1 (4.9)
i=1 pA,i,t
where βiIA =value share of intermediate good i in total investment, and ΩI =scale
parameter.
4.2.2 Foreign Trade
4.2.2.1 Product Differentiation for Exports
Domestically produced sectoral goods are converted through a constant elasticity of

transformation (CET) function into specific goods destined for the domestic market
(Hi,t ) and goods destined for the export market (Xi,t ). The derived pricing equation
is given by:
  1
!1+σHX 1+σHX 1+σHX
βiX p f ,t pH,i,t pY,i,t (1 + tY,i )

+ βiH  = (4.10)
p f ,t pH,i,t pY,i,t (1 + t Y,i )
where βiX =value share of exports, βiH =value share of domestic consumption
in domestic production, p f ,t =price for foreign exchange, pH,i,t =price for Hi,t ,
pY,i,t =price for Yi,t , tY,i =output tax in sector i, σHX = elasticity of transformation.
Following the small open economy assumption, export and import prices in foreign
currency are not affected by the behavior of the domestic economy. In other words,
the small open economy faces infinitely elastic world export demand and world im-
port supply functions.
4.2.2.2 Armington Assumption
Similarly to the export side, we adopt the Armington assumption of product het-
erogeneity for the import side. A CES function characterizes the choice between im-
ported and domestically produced varieties of the same good. The associated pricing
equation is given by:
 !1−σAR,i  1−σ1AR,i
pH,i,t 1−σAR,i

pA,i,t (1 + tAR,i ) AH p f ,t
= ΩA,i βi
 + βiAM 
pA,i,t (1 + t AR,i ) pH,i,t p f ,t
(4.11)
where Ai,t =Armington good, ΩA,i =scale parameter, βiAH =value share of domestic
production in domestic consumption, βiAM =value share of imports, pA,i,t =price of
Armington good, tAR,i = tax on Armington goods, σAR,i = elasticity of substitution
of sector i.
The representation of foreign and domestic goods as imperfect substitutes has
the implication that although there is a constant interest rate on the international
bond market, the domestic interest rate may deviate from the world market rate
during a transition period. This happens because building up the domestic capital
stock requires domestic as well as imported inputs. An increase in the capital stock
thereby drives up the relative price of domestic output and the domestic interest rate
until the economy settles in a new steady state with constant relative prices.
4.2.2.3 Supply of and Demand for Domestic and Foreign Goods
From (4.10), supply of sectoral production i to the domestic and export market is:
−σHX
Hi,t Yi,t pY,i,t (1 + tY,i ) pH,i,t
= (4.12)
H i,t Y i,t pY,i,t (1 + t Y,i ) pH,i,t
−σHX
pY,i,t (1 + tY,i ) p f ,t

Xi,t Yi,t
= (4.13)
X i,t Y i,t pY,i,t (1 + t Y,i ) p f ,t
and from (4.11), Armington demand for domestic and imported variety of good i is
given by:
Ai,t pA,i,t (1 + tAR,i ) pH,i,t σAR,i

Hi,t
= (4.14)
H i,t Ai,t pA,i,t (1 + t AR,i ) pH,i,t
Ai,t pA,i,t (1 + tAR,i ) p f ,t σAR,i

IMi,t
= . (4.15)
IMi,t Ai,t pA,i,t (1 + t AR,i ) p f ,t
4.2.3 Households
The household side of the model is disaggregated both within and across generations.
In each period, eight new households corresponding to eight income classes enter
the model. Each household is characterized by overlapping generations and has a
finite and known lifespan in which they engage in market activities. In each period
over the life cycle, households are endowed with units of productive time that they
allocate between labor and leisure. Households are assumed to be forward-looking
individuals that form rational point expectations (perfect foresight). Each household
maximizes lifetime utility by choosing optimal consumption and leisure paths over
the life cycle subject to a lifetime budget and time endowment constraint. There is
no aggregate or household-specific uncertainty.
4.2.3.1 Utility Maximization
A household of generation g and type h = 1, . . . , H is born at the beginning of year

t = g, lives for N + 1 years, and is endowed with ωg,t units of time in each period
g ≤ t ≤ g+N. Time endowment, i.e. the size of a household, varies across generation
and time and is selected to match real German demographic data. Generations born
prior to year zero and that are alive in the first model period are indexed by g =
−N, . . . , −1. Adopting again the calibrated share form, the optimization problem
for a generation g = −N, . . . , ∞ and household type h = 1, . . . , H, expressed with
present value prices, is given by:
  σh
g+N 1−σh 1−σh
zg,h,t σh
max ug,h zg,h,t =  ∑ θg,h,t  (4.16)
cg,h,t , `g,h,t t=g zg,h,t
subject to:
  νh
1−νh ! 1−νh 1−νh
νh
zg,h,t cg,h,t νh `g,h,t
= αh + (1 − αh ) (4.17a)
 
zg,h,t cg,h,t

`g,h,t
  κh
1−κh ! 1−κh 1−κh
cNF κh

cg,h,t a1,g,h,t κh
g,h,t
= θhF + θhNF (4.17b)
 
cg,h,t a1,g,h,t cNF

g,h,t
  σNF
1−σNF 1−σNF
cNF

g,h,t ai,g,h,t σNF
= ∑ ϕi,h,t  (4.17c)
cNF
g,h,t i∈NF ai,g,h,t
g+N
∑ pa,g,h,t cg,h,t ≤ pk,t kg,h,g + p f ,t bg,h,g
t=g
g+N
+ ∑ pl,t πg,h,t (ωg,h,t − `g,h,t ) + p f ,t ζg,h,t (4.17d)
t=g
`g,h,t ≤ ωg,h,t (4.17e)
cg,h,t ≥ 0 , `g,h,t ≥ 0 . (4.17f)
Figure 4.3 visualizes the nesting structure of lifetime utility. Lifetime utility (ug,h )
is additively separable over time, and instantaneous utility (zg,h,t ) enters according
to a constant-intertemporal-elasticity-of-substitution (CIES) function. θg,h,t = share
parameter which accounts for discounting, and σh = is the intertemporal elasticity

of substitution. In the first sub-nest, a consumption aggregate (cg,h,t ) and leisure
consumption (`g,h,t ) enter in a CES fashion, and ν =elasticity of substitution be-
tween consumption aggregate and leisure, and αh =value share of material con-
sumption. We distinguish between food and non-food products as empirical price
elasticities typically differ substantially. Food products (a1,g,h,t ) and an aggregate of
non-food products (cNF F
g,h,t ) enter in a CES function. θh =value share of food products,
NF
θh =value share of non-food products, and κh =elasticity of substitution between
food and non-food products. In the bottom nest, non-food consumption of Arming-
ton goods (ai,g,h,t ) enters in a CES aggregator trading off at a constant elasticity of
substitution of σNF .3 ϕi,h,t is the value share of a single non-food consumption good
i in cNF
g,h,t . ϕi,h,t is assumed to differ across households types and time to allow for
distinct preferences across households that belong to different income classes; for
instance, expenditures for food products typically make up a larger fraction of dis-
posable income for low-income than for richer households. Also, the composition
of final demand is assumed to vary with age, i.e. preferences are age-dependent. Em-
pirically, older people consume more health care services than younger households
while spending on transport and communication typically declines with age.4
Utility maximization is subject to a number of constraints as described by
(4.17d)–(4.17f). The present value of total consumption expenditure over the life-
time cannot exceed the present value of lifetime income which is derived from sup-
plying labor (ωg,h,t − `g,h,t ) and transfer income where ζg,h,t is a lump sum trans-
fer from the government which is denominated in the price of foreign exchange.
This rules out that households die in debt. For later reference let lifetime income
g+N
be defined as follows: incg,h = ∑t=g pl,t πg,h,t (ωg,h,t − `g,h,t ) + p f ,t ζg,h,t . We do not
consider altruistic behavior thereby ruling out bequests or any other form of inter-
generational transfers. px,t , x = {k, l, f }, denote the purchase price of capital, the
wage rate, and the price of foreign exchange, respectively. pa,g,h,t is the price for the
(household-specific) composite consumption good. πg,h,t is an index of labor produc-
tivity over the life cycle. kg,h,g denotes the asset holdings of generation g at time t = g
that represent claims on the domestic capital stock. bg,h,g represents the amount of
assets being held in foreign currency. Current old generations, i.e. generations born
prior to period zero, are endowed with non-zero assets of either type whereas all
newborn households enter the economy with zero assets: kg,h,g = bg,h,g = 0, ∀ g ≥ 0,
and ∀ h. Total asset holdings of current old generations that are denominated in pk,t
must equal the value of the domestic capital stock. We assume that the government
and the trade deficit are both denominated in the price of foreign exchange. Hence,
the total value of net foreign assets in period zero is equal to the present value of fu-
3 Note that in the present setup, the assumption of multi-stage budgeting is innocuous since the
utility function u is weakly separable and the sub-utility functions z and c are homothetic.
4 In reality, preferences may not only be age- but also cohort-dependent. Empirical evidence for
Germany, however, suggests that cohort effects appear to be small (Börsch-Supan, 2004). The
adopted notion of household preferences thus assumes that preferences vary with age but are stable
across generations. For a more detailed discussion see Section 4.5.1.
lifetime utility U g,h
σh
z g,h,1 z g,h,t z g,h,
νh
leisure g,h,t consumption aggregate g,h,t
κh
Armington goods food 1,g,h,t non-food g,h,t
σNF
a 2,g,h,t a i,g,h,t a I,g,h,t
Fig. 4.3 Utility nesting
ture trade and government deficits over the infinite horizon.5 Finally, in each period
of the life cycle, time allocated to leisure consumption cannot exceed the time en-
dowment ωg,h,t (4.17e). Choices for material and leisure consumption are restricted
to be nonnegative (4.17f).
4.2.3.2 Pricing Equations and Household Demand
The dual cost functions that correspond to the CES functions (4.16)–(4.17c) in the
household optimization problem are given by:
" 1
g+N 1−σh # 1−σ h
pu,g,h pz,g,h,t
= ∑ θg,h,t (4.18)
pu,g,h t=g pz,g,h,t
5 The initial distribution of domestic and foreign assets across current old generations is selected
such that the economy is on a balanced growth path (for details on the calibration procedure see
Section 4.3).
" # 1
pc,g,h,t 1−νh p`,g,h,t 1−νh 1−νh

pz,g,h,t
= αh + (1 − αh ) (4.19)
pz,g,h,t pc,g,h,t p`,g,h,t
 1
!1−κh  1−κ
pNF h
1−κh
pc,g,h,t  F pA,i,t (1 + τc ) c,g,h,t
= θh + θhNF  (4.20)
pc,g,h,t pA,i,t (1 + τ c ) pNF
c,g,h,t
" 1−σNF # 1−σ1NF

pNF

c,g,h,t pA,i,t (1 + τc )
= ∑ ϕi,h,t (4.21)
pNF
c,g,h,t i∈NF pA,i,t (1 + τ c )
where pu,g,h =price of intertemporal utility, pz,g,h,t =price for zg,h,t , pc,g,h,t =price
for composite consumption good, pNF c,g,h,t =price index for non-food aggregate,
τc =time-invariant tax on consumption, and p`,g,h,t =price for leisure consumption.
Instead of dividing households into groups of workers and retirees, the model al-
lows for optimal endogenous retirement decisions on behalf of the households. The
equilibrium allocation involves a corner solution with respect to labor supply if the
reservation wage exceeds the market wage rate, i.e. if:
p`,g,h,t ≥ pl,t πg,h,t . (4.22)
A positive amount of labor is supplied if (4.22) holds with equality. For future refer-
ence, labor supply is denoted by lg,h,t . Household demand functions can be written
as:
ug,h pu,g,h pz,g,h,t σh

zg,h,t
= (4.23)
zg,h,t ug,h pu,g,h pz,g,h,t
zg,h,t pz,g,h,t pc,g,h,t νh

cg,h,t
= (4.24)
cg,h,t zg,h,t pz,g,h,t pc,g,h,t
νh
zg,h,t pz,g,h,t p`,g,h,t

`g,h,t
= (4.25)
`g,h,t zg,h,t pz,g,h,t p`,g,h,t
κh
ai,g,h,t cg,h,t pc,g,h,t pA,i,t
= for i = 1, (4.26a)
ai,g,h,t cg,h,t pc,g,h,t pA,i,t
NF
!κh !σNF
ai,g,h,t cg,h,t pc,g,h,t pc,g,h,t pNF
c,g,h,t pA,i,t
= , for i ∈ NF . (4.26b)
ai,g,h,t cg,h,t pc,g,h,t pNF
c,g,h,t pNF
c,g,h,t pA,i,t
4.2.4 Government
The government collects revenue from levying ad-valorem taxes (tY,i ) on sectoral
production (Xi,t and Hi,t ), and ad-valorem taxes (tAR,i ) on Armington production
(Ai,t ). We assume that the government budget is balanced over the infinite horizon,
and that there is a constant tax rate on consumption (τc ) that is determined endoge-
nously such that:
∞ ∞
p f ,0 AG,0 + ∑ Φt = ∑ Γt (4.27)
t=0 t=0
where AG,0 is the initial level of assets held by the government, which enters
the model as an exogenous endowment. Total per period tax revenue is given by:
Φt = ∑Ii=1 tY,i (pX,i,t Xi,t + pH,i,t Hi,t ) + tAR,i pA,i,t Ai,t + τc pC,t Ct , where p’s are rele-
vant prices and Ct denotes aggregate consumption. Government expenditure com-
prises government consumption (Gt ) and total transfers to households (Tt ) which
are denominated in the price of foreign exchange: Γt = pG,t Gt + p f ,t Tt . Government
demand combines inputs from the production sectors in fixed proportions:
I
pG,t pA,i,t
= ∑ βiGA (4.28)
pG,t i=1 pA,i,t
where βiGA =value share of intermediate good i in total government consumption,

pG,t =price of total government consumption.
4.2.5 Market Clearing Conditions and Model Closure
Armington goods can be used as intermediate inputs in production, or enter in house-

hold, government and investment demand. The market clearing condition for good
i is therefore given by:
Ai,t = CA,i,t + Ii,t + Gi,t + ∑ Ai, j,t , i 6= j (4.29)

j
where due to the presence of inter- and intragenerational household heterogeneity,

total private consumption of good i is:
t H
CA,i,t = ∑ ∑ ai,g,h,t (4.30)
g=t−N h=1
and Ii,t and Gi,t denote the investment and government demand for Armington good
i, respectively. The market clearing conditions for primary factors of production are:
I
Kt = ∑ Ki,t (4.31)
i=1
I
Lt = ∑ Li,t (4.32)
i=1
where aggregate labor supply (Lt ) also has to be consistent with individual house-
hold decisions:
t H
Lt = ∑ ∑ lg,h,t πg,h,t . (4.33)
g=t−N h=1
Using (4.12) and (4.14), the market clearing condition for sectoral output i destined
for the home market is:
Yi,t pY,i,t (1 + tY,i ) pH,i,t −σHX Ai,t pA,i,t (1 + tAR,i ) pH,i,t σAR,i

= . (4.34)
Y i,t pY,i,t (1 + t Y,i ) pH,i,t Ai,t pA,i,t (1 + t AR,i ) pH,i,t
The shadow price of “time”, or the price for leisure, adjusts to equalize available
time resources and the amount of time that goes into labor supply and leisure activi-
ties:
ωg,h,t = lg,h,t + `g,h,t (4.35)
where lg,h,t is a complementary variable determined by (4.22). The market clearing
condition for government consumption is given by:
Gt = Gt . (4.36)
The market clearing condition for the capital stock is given by:
t H
Kt−1 (1 − δ ) + It−1 + ∑ ∑ kg,h,g = Kt . (4.37)
g=t−N h=1
This equation simply restates (4.7) and also takes into account initial asset holdings
by households alive in year zero that represent claims on the domestic capital stock
(third summand on the left hand side). A similar version holds for the post-terminal
capital stock (see Appendix 4.6, equation (4.51)). Lifetime utility is given by:
incg,h
ug,h = . (4.38)
pu,g,h
Prices for the consumption aggregates zg,h,t and cg,h,t that enter utility are given by
the following market clearing conditions:
zg,h,t = zD
g,h,t (4.39)
cg,h,t = cD
g,h,t (4.40)
where zD D
g,h,t and cg,h,t denote respective demands given by (4.23) and (4.24). Finally,
we fix the value of the trade deficit over the infinite horizon and it may therefore de-
viate from the baseline level in individual periods. Instead of imposing this relation-
ship directly, however, we require balance in all goods and transfers denominated
in foreign exchange. Because of the assumption of perfect international capital mar-
kets the current value price of exports and imports is constant and we therefore only
operate with a single price for foreign exchange determining the level, denoted by
p f . The present value price for foreign currency is given by p f ,t = (1+r)−t p f where
r denotes the world interest rate. The market clearing condition for foreign currency
is:
!
t H
∑ p f ,t Dt − Tt + ∑ ∑ ζg,h,t + bg,h,g = ∑ ∑ p f ,t (IMi,t − Xi,t ) (4.41)
t g=t−N h=1 t i
where Dt denotes the periodic government deficit denominated in the price of for-
eign exchange.
4.2.6 Equilibrium
We now define the dynamic general equilibrium of this economy in a comple-

mentarity format. Rutherford (1995b) and Mathiesen (1985) have shown that a
complementary-based approach is convenient, robust, and efficient. A characteris-
tic of economic models is that they naturally involve a complementary problem,
i.e. given a function F : Rn −→ Rn , find z ∈ Rn such that F(z) ≥ 0, z ≥ 0, and
zT F(z) = 0. A fundamental advantage of formulating an economic model as a com-
plementary problem is the ability to express weak inequalities and complementary
slackness. This formulation of the equilibrium is exploited by the GAMS program
and the solver we use to compute the transition and steady state of the infinite-
horizon economy.6 An equilibrium in complementarity format is represented by a
vector of activity levels, a non-negative vector of prices, and a non-negative vector
of incomes such that:
1. no production activity makes a positive profit (zero profit conditions),
2. excess supply (supply minus demand) is non-negative for all goods and factors
(market clearance conditions), and
3. expenditure does not exceed income (budget constraints).
Zero-profit conditions exhibit complementary slackness with respect to associated
activity levels, market clearing conditions exhibit complementary slackness with re-
spect to market prices, and budget constraints define income variables. Adopting
this type of equilibrium formulation, Table 4.1 shows each inequality, its associated
or so-called complementary variable, and the number of unknowns. In order to ap-
proximate the infinite horizon economy by a finite dimensional complementarity
problem, it is necessary to impose a number of additional constraints on the system
of equations defined above. See Section 4.6 for more details.
4.3 Calibration and Data
In this section we discuss the specification of model parameters, the data that is
used as model inputs, and aspects of the numerical implementation. In terms of
6 For an overview of applied general equilibrium modeling with GAMS (General Algebraic
Modeling System) and the GAMS/MPSGE subsystem see e.g. Rutherford(1998,1999a), and
http://www.mpsge.org.
4.3 Calibration and Data 97
Table 4.1 Inequalities and associated complementary variables
Complementary variable Inequality Number of unknowns

Activity level Zero profit inequality
Yi,t (4.1) I×T
Kt (4.8) T
It (4.9) T
Ai,t (4.11) T
Gt (4.28) T
ug,h (4.18) G×H
zg,h,t (4.20) G × H × (N+1)
cg,h,t (4.21) G × H × (N+1)
lg,h,t (4.22) G × H × (N+1)
Price Market clearing inequality
pY,i,t (4.14) I×T
pA,i,t (4.29) I×T
pr,t (4.31) T
pl,t (4.32) T
pk,t (4.37) T
p f ,t = p f (1 + r)−t (4.41) 1
pu,g,h (4.38) G×H
p`,g,h,t (4.35) G × H × (N+1)
pG,t (4.36) T
pz,g,h,t (4.39) G × H × (N+1)
pc,g,h,t (4.40) G × H × (N+1)
Income variable Income definition
incg,h (4.17d) G×H
gov (4.52) 1
Variable Additional constraints1
τc (4.27) 1
1: See Appendix 4.6 for more details.
calibration, we need to choose parameters governing the demographic transition, the

production technology, tax rates, endowments, and preferences. Table 4.12 provides
an overview of the model parameters.
4.3.1 Numerical Implementation
The equilibrium path of the overlapping generations model is determined by em-

ploying the decomposition algorithm which has been described in Chapter 2. The
algorithm approximates the equilibrium of the OLG economy by solving a sequence
of appropriately chosen Ramsey growth problems. In each iteration, demand func-
tions of OLG households are evaluated given a candidate price vector that has been
computed solving a “related” representative agent Ramsey growth model. In the sub-
sequent iteration, the general equilibrium of an updated Ramsey growth problem
is computed. Updating involves the recalibration of the (artificial) representative

agent’s utility function based on households’ “partial equilibrium” quantity choices
from the previous iteration. The model is solved in one-year intervals.
4.3.2 Thought Experiment and Calibration of the Model
The way we use the model may be somewhat unconventional in CGE modeling be-
cause we do not perform counterfactual policy analysis but rather use the model as a
projection tool that is fed with demographic data. The thought experiment which un-
derlies the simulations is the following: we take a time-varying demographic struc-
ture as the exogenous driving process that evolves according to demographic projec-
tions by the Federal Statistical Office of Germany. This transition of the population
structure induces a transition path of the economy.
We calibrate the model to the base year 2003 using Input-Output data for Ger-
many and various other data sources.7 For the present application calibration is a
complex task because non-stationarity of the population data implies that the econ-
omy is not on a balanced growth path.8 Our calibration strategy proceeds in two
steps. First, we assume (contra-factually) an initial steady state situation for the
base year 2003, and exploit this assumption to calibrate a number of household pa-
rameters (see Section 4.3.6).9 Then, in order to find the baseline equilibrium path in
the presence of non-stationary population dynamics and to ensure that the base year
data is reproduced endogenously, it is necessary to impose a number of restrictions
on the entire transition model. In our case, technology parameters ΩY,i , ∀i, are cal-
ibrated such that the model replicates sectoral output data in the first model period.
Similarly, ΩA,i , ∀i, and ΩI are solved for endogenously to match base year values
of Armington production and investment, respectively.
To ensure consistency between household behavior and aggregate benchmark
data, it is necessary to solve endogenously for two of the parameters in the individ-
uals’ optimization problem. Rasmussen and Rutherford (2004) present a calibration
7 Our calibration strategy which focuses exclusively on observations of a base year—as for the
OLG context, e.g., in Jensen and Rutherford (2002) and Rasmussen and Rutherford (2004)—
constitutes one possible way of calibrating OLG models to empirical data. This procedure differs
from the approach in Auerbach and Kotlikoff (1987) or Altig, Auerbach, Kotlikoff, Smetters and
Walliser (2001) where parameters are simply chosen so as to generate “reasonable” outcomes by
informally matching long term averages of statistical data. A more systematic approach would be
to perform a so-called “dynamic calibration” by choosing time-varying model parameters to match
observed time series data. This is an ongoing area of research; see, e.g., Ludwig (2005) who sug-
gests to estimate free model parameters by using method of moments methodology that sets to
zero the average discrepancy between actual and predicted (simulated) values. Future work needs
to compare how alternative approaches to model calibration may influence model results.
8 See, e.g., Wendner (1999) for a detailed discussion.
9 We select initial asset holdings k
g,h,g and bg,h,g by assuming (contra-factually) that the economy
is on a balanced growth path, and use the procedure as described in Rasmussen and Rutherford
(2004). The time preference rate ρ is calibrated such that the value of total household consumption
equals aggregate consumption in the base year.
procedure that can be used for situations where the economy is assumed to be on
a balanced growth path. It is, however, straightforward to extend their procedure to
non-steady state situations. In the present case, the nature of the decomposition algo-
rithm that we used to compute the transition path of the economy, and that makes it
possible to solve such a large-scale model in the first place, prevents the application
of such a calibration procedure.10 As a consequence, the value of private consump-
tion and the value of total domestic and foreign assets deviate from the benchmark
data.
4.3.3 Input-Output Data
We employ a social accounting matrix (SAM) for Germany, which is based on Input-
Output (IO) data for the year 2003 issued by the Federal Statistical Office of Ger-
many, and which distinguishes 17 production sectors.11 Table 4.2 lists the names
(and acronyms) of the industrial sector aggregates and describes the subsumed in-
dustries from the original IO data compounded in each sectoral aggregate. This level
of aggregation captures most of the interesting sectors of the German economy that
would be affected by demographic change. In particular, transportation and commu-
nication, banking and insurance services, real estate services, education, and health
services are included as separate sectors.
For aggregation, we include all 71 industries of the German IO table. We adjust
base year investments to obtain a micro-consistent12 SAM which is consistent with
a momentary general equilibrium in the base year. The calibration of technologies
using base year data on prices and quantities is a standard exercise in CGE modeling,
and hence needs no further discussion (see, e.g., Robinson (1991) and Rutherford
(1999a) for a general discussion and Rasmussen and Rutherford (2004, pp.1405) for
an application in an OLG context). Based on the IO data for Germany, we are able
to obtain numerical values for all share parameters (β ’s and χ’s).
10 Since the algorithm decomposes the OLG economy into a representative agent model and a par-
tial equilibrium problem, and involves an iterative procedure between these two subproblems, im-
posing calibration restrictions on the representative agent model does only work if the parameters
used for calibration do not alter demand functions of OLG households. Otherwise, the algorithm’s
search dynamics are profoundly altered because the endogenized parameters become part of the
adjustment process. In this case, we find that the “Sequential Recalibration” algorithm does not
converge, and is therefore not useful in finding the true equilibrium allocation. This also explains
why we have only used technology parameters for calibration of the aggregate economy.
11 Our SAM is based on the Input-Output table 1.1., Issue 18 (2), Federal Statistical Office of
Germany.
12 The SAM incorporates an internally consistent set of relationships. Among the most important
identities in the SAM are zero profits for each production activity, market clearance for all com-
modities and factors, budget balance for households and the government, and the value of imports
equals the value of exports, net of capital flows. In fact, an Arrow-Debreu type applied general
equilibrium model, such as this one, must be based on a SAM; otherwise the data would be incon-
sistent with the underlying behavioral assumptions of the model (which are based on optimizing
behavior of all agents subject to budget constraints and adding up conditions).
Table 4.2 Industrial sector aggregates
Sectoral aggregate in model Single industries and CPA1 numbers

in German IO table
Agriculture and Fisheries (AGF) 01,02,05: Erzeugnisse der Land- und Forst-
wirtschaft, Fischerei
Mining (MIN) 10-14: Bergbauerzeugnisse, Steine und Erden
Food Products (FOP) 15,16: Nahrungs- und Futtermittel, Getrnke,
Tabakerzeugnisse
Textiles and Leather Products (TXL) 17,19: Textilien, Bekleidungs- und Lederwaren
Printing and Publishing (PRP) 20-22.3: Erzeugnisse des Holz-, Papier-, Druck-
und Verlagsgewerbes
Mineral and Chemical Products (MIC) 23-26.8: Mineralölerzeugnisse, chemische Erzeug-
nisse, Glas, Keramik, bearbeitete Steine und Erden
Metals (MET) 27.1-28: Metalle
Machinery (MAC) 29-35: Maschinen, Fahrzeuge, Datenverarbeit-
ungsgeräte,elektrotechn. Geräte
Personal Goods (PGO) 36,37: Möbel, Schmuck, Musikinstrumente u.ä.
Construction, Energy, and Water (CEW) 40.1-41: Bauarbeiten, Energie und Wasser
Wholesale and Retail Trade (WRT) 50-52,55: Handelsleistungen und DL des Gastgew.
Transportation and Communication (TRC) 60.1-64: Verkehrs- und Nachrichtenübermittlungs-DL
Banking and Insurance Services (BIN) 65-67: DL der Kreditinstitute und Versicherungen
Real Estate Services (RES) 70-74: DL des Grundstcks- und Wohnungswesens,
Unternehmens-DL
Public Services (PBS) 75.1-75.3,90-95: DL der öffentl. Verwalung, Vertei-
digung, DL von Interessensvertretungen,Kirchen u.ä.,
Kultur-, Sport- und Unterhaltungs-DL, Abfallbeseitig-
ungs- u. sonstige, Entsorgungsleistungen,
Sonstige DL, DL privater Haushalte
Education (EDU) 80: Erziehungs- und Unterrichts-DL
Health (HEA) 85: DL des Gesundheits-, Veterinär- und Sozialwesens
Note: 1: For reference we give CPA numbers that identify each single industry that is used in
aggregation. CPA = Classification of Products by Activity according to Eurostat. Abbreviations
used: DL = Dienstleistungen.
4.3.4 Representation of the Household Sector
Within each generation we distinguish between eight different socio-economic

groups representing the eight income classes according to the German Income and
Expenditure Survey (EVS) for the year 2003.13 The EVS is a representative house-
hold survey by the Federal Statistical Office of Germany. The 2003 sample com-
prises 53,432 households. Table 4.3 summarizes the principal characteristics of the
household types. Note that transfers to households comprise pensions, unemploy-
ment benefits and various social transfers.14 This broad definition of transfer income
13 Source: Einkommens- und Verbrauchsstichprobe — Einnahmen und Ausgaben privater

Haushalte, Issue 15 (4), Federal Statistical Office of Germany.
14 This definition follows the classification in the original EVS data.
Table 4.3 Household characteristics according to EVS
Household group Annual income Population Labor Annual transfers

(in e) size1 share per capita (in e)
h=1 (poorest) (< 10800) 3.04 0.01 6,096
h=2 (10800 − 15600) 4.67 0.03 8,496
h=3 (15600 − 18000) 2.32 0.02 8,580
h=4 (18000 − 24000) 5.30 0.07 9,960
h=5 (24000 − 31200) 5.61 0.10 12,276
h=6 (31200 − 43200) 7.32 0.22 11,712
h=7 (43200 − 60000) 5.54 0.25 12,024
h=8 (richest) (> 60000) 4.31 0.32 14,436
Note: The different socio-economic groups represent the eight income classes according to the
German Income and Expenditure Survey (EVS) for the year 2003. 1: Population size refers to the
(extrapolated) number of households in million. Labor share denotes the share of the sum of labor
incomes earned by all households in this income class in the economy-wide labor income.
explains the positive correlation with the level of total household income. In the sim-
ulations later on, transfer income per capita is held constant.
Following Auerbach and Kotlikoff (1987), we assume an age-related labor effi-
ciency endowment profile which has the following form:
πg,h,t = ζˆscale,h exp 4.47 + λ0 (t − g) − λ1 (t − g)2 / exp [4.47]

where λ0 = 0.032, λ1 = 0.003. Not surprisingly, results are sensitive with respect
to the numerical specification of πg,h,t , and we will explore this in Section 4.5. To
match the observed labor share of each income class, we augment their specifica-
tion by proportionally scaling the labor productivity index by a factor ζˆscale,h . It is
assumed that transfers within each household group between individuals of differ-
ent age are distributed equally, i.e. the level of transfers is kept constant over the
life cycle. We set the value share of material consumption (αh ) equal to 0.8 for all h.
Expenditure shares for consumption of Armington good i (ϕi,h,t ) are taken from the
value shares of aggregate consumption as given by the IO table. Hence, in our bench-
mark model, households across groups and age are assumed to have homogenous
preferences and only differ with respect to labor productivity and transfer income.
We will relax this assumption later on to analyze the effect of structural changes in
the final demand composition of old vis-à-vis young people. Homogeneity of pref-
erences in the baseline considerably eases the calibration of the model and, more
importantly, provides a way of disentangling the demand-side induced effects of
population aging.
4.3.5 Demographic Projections
Demography is taken as the major exogenous driving force in the simulation

model.15 We use detailed demographic data by the Federal Statistical Office of Ger-
many that covers the years from 2003 to 2050.16 Population data is given at an
annual frequency for age-groups of individual years. We assume that households
enter economic life at the age of 16 and have a deterministic lifetime of 74 periods
(the maximum age of households in the model is therefore 90 years). Population
statistics enter the model via the time endowment parameter ωg,h,t in (4.17d). In or-
der to obtain the size of household groups we use data on population shares from
Table 4.3. We assume that population aging affects all household groups equally.
To extrapolate population data beyond 2050 age-group specific population growth
rates are projected linearly such that the working-age population ratio remains con-
stant between 2050 and 2100. After 2100, we assume a constant population growth
rate to eventually produce a stable population which supports a final steady state
equilibrium.
4.3.6 Calibration of Free Parameters
4.3.6.1 Calibration of Utility Functions
Calibration of the parameters of the utility function requires the integration of em-
pirical estimates for labor supply and consumption demand. We set the intertempo-
ral elasticity of substitution (σh ) to 0.8, ∀h. In the literature values range from 0.5
(Jensen and Rutherford, 2002) to around 1.0 (Krueger and Ludwig, 2007). The elas-
ticity of substitution between consumption and leisure (νh ) is partly determined by
uncompensated labor supply elasticities. Although there is information in the liter-
ature about uncompensated labor supply elasticities, we are not aware of empirical
estimates that take into account variations with age. Due to this lack of informa-
tion, we cannot calibrate νh , and assume a uniform and time-independent elasticity
for all household groups. Estimates typically lie around 0.8 (Altig et al., 2001) and
1.0 (Jensen and Rutherford, 2002). We set ν = 0.8. Following Börsch-Supan et al.
(2006), the consumption share parameter (αh ) is set to 0.6, ∀h.
To calibrate the remaining elasticity parameters we use empirical estimates on
uncompensated price elasticities of consumption demand. Given data on share pa-
rameters (θ F , θ NF , and ϕi ), and given the nesting structure of utility (see Figure
4.3) we can solve recursively, in line with Rutherford (1995b), for the elasticities of
15 Assuming exogenous demographic processes is of course a simplifying assumption since, in the

long run, neither fertility nor mortality and of course not migration are exogenous to economic
activity.
16 For the demographic projections, we use the results of the Eleventh Coordinated Population
Forecast 2005, Variant 1-W2 issued by the Federal Statistical Office of Germany.
interest, κ and σNF :
εF = −νθ F (1 − α) + θ F α − κ(1 − θ F ) (4.42)

NF NF NF NF NF
ε NF = −κθ (1 − θ NF ) − ν θ (1 − α) − θ θ α − σ NF (1 − θ ) (4.43)
where εF =uncompensated own-price elasticity of food demand, ε NF =average un-
NF
compensated own-price elasticity of demand for non-food goods, and θ =average
share of individual non-food goods in the non-food aggregate. With respect to the
specification of price elasticities of demand we draw on Boeters et al. [2008] and
set εF = −0.222 and ε NF = −0.563.
4.3.6.2 Elasticities of Substitution in Production
The main reference for elasticities of substitution in German production is Böhrin-

ger, Boeters, and Feil (2005,p.103) who draw on estimates by Falk and Koebel
(1997). Using the demand equation (4.5), the following relationship between the
uncompensated labor demand elasticity and the elasticity of substitution between
labor and capital in sector i applies:
ηi = −(1 − βiL )σVA,i − θiL (4.44)
where θiL =value share of labor in total production costs of sector i.17 Available
data on uncompensated elasticities from Böhringer et al. (2005) distinguishes be-
tween unskilled and skilled labor. For the homogeneous labor in the model, we take
averages of these estimates and set: ηAGF = −0.33, ηMIN = −0.16, ηTXL = ηPRP =
ηMIC = ηMET = ηFOP = ηMAC = ηPGO = −0.80, ηCEW = −0.48, ηWRT = ηTRC =
−0.19, and ηBIN = ηRES = ηPBS = ηEDU = ηHEA = −0.44.
The following Armington elasticities are taken from Welsch (2008)18 : σAR,AGF =
0.081, σAR,MIN = 0.915, σAR,FOP = 0.841, σAR,TXL = 0.926, σAR,PRP = 0.300, σAR,MIC
= 1.600, σAR,MET = 0.687, σAR,MAC = 2.360, σAR,PGO = 0.184, σAR,CEW = σAR,WRT =
σAR,TRC = σAR,BIN = σAR,RES = σAR,PBS = σAR,EDU = σAR,HEA = 0.871. All sectoral
aggregates are treated as tradable goods. The elasticity of transformation between
domestically supplied and exported goods is uniformly set to σHX = 2.
The depreciation rate of the capital stock is derived using information from the
Federal Statistical Office of Germany on the (gross) value of capital and deprecia-
tion.19 Based on this, we calculate an annual depreciation rate of δ = 0.029.
17 For the relation between compensated and uncompensated elasticities, see, e.g., Hamermesh
(1993).
18 Due to differences in industry classification, we use the country average of .871 for those sectoral
aggregates for which there is no counterpart in Welsch (2008).

19 Kapitalstockrechnung in Deutschland, 2006, Federal Statistical Office of Germany, pp. 1121.
The depreciation rate is calculated as the the ratio of Abschreibungen auf das Anlagevermögen in
jeweiligen Preisen to Kapitalstock.
4.3.7 Government
Across all scenarios, we assume that the government maintains fixed expenditure
shares for all sectoral goods according to the baseline path. It is important to stress
that this assumption neglects to take into account the growing political influence of a
larger share of older generations, something which is likely to affect the preferences
of the government. Reported equilibrium outcomes, e.g., with respect to sectoral
changes in public services and health care therefore have to be interpreted as conser-
vative estimates. Furthermore, to provide a reasonable basis for welfare analysis, it
is critical to assume that government transfers per capita in each age and household
group remain fixed. Lastly, we hold government expenditures constant in per capita
terms. Without this assumption the share of government consumption in real GDP
would become unrealistically large.
4.4 Results of the Benchmark Model
The model allows us to investigate a wealth of economic effects arising from the on-
going and projected population aging in Germany. The population dynamics induce
a transition path of the economy both in terms of aggregate and sectoral variables
as well as in terms of cross-sectional and intergenerational distributions of income,
wealth and welfare. The analysis of these changes will provide us with answers as
to how the change in the demographic structure of the economy affects key macroe-
conomic and household variables by changing relative goods prices and returns to
capital and labor.
We compute the model equilibrium from 2003 to 2200 and report simulation
results for the main projection period of interest, from 2003 to 2050. We do not re-
port results after 2050 because these hinge crucially on the assumptions concerning
the projection of demographic data beyond 2050. Actually, simulation results suffi-
ciently close to 2050 are already sensitive to demographic projections made beyond
2050 because of the forward-looking nature of the model, and therefore have to be
interpreted with care. The base year 2003 is taken as the main year of reference to
evaluate future changes in the projected time path of variables.
The benchmark model assumes that household preferences do not vary with age.
In Section 4.5, we will modify this assumption in order to assess the quantitative
importance of demand-side induced effects of population aging that results from
structural changes in the composition of old-age consumption.
4.4.1 Macroeconomic Effects of Population Aging
Table 4.4 reports on the dynamic impact of population aging on key aggregate statis-
tics. The projected percentage changes are presented with respect to the base year
4.4 Results of the Benchmark Model 105
equilibrium solution in 2003. Output per capita is projected to steadily decrease dur-
ing the transition, ending up in 2050 on a 7% lower level than in the year 2003. The
change in output per capita is mainly due to two effects. As the most direct effect, the
decrease in the overall population means that existing resources have to be shared
by less people. However, the ongoing aging of the population also directly reduces
the labor force which, as a factor of production, suppresses output. Aggregate labor
supply (measured in efficiency units) is shown to drop substantially by around 17%.
This second negative effect largely dominates and output per capita declines. The
consumption-output ratio increases by around 1.4% in 2010 and by almost 10% in
2050. This is consistent with the increasing share of older people in the economy that
are dis-savers and hence consume a larger fraction out of their periodic income as
compared to younger households. Consumption per capita, however, stays roughly
constant. The investment-output ratio drastically drops by about 10% in 2010, and
by 26% in 2050. As the population ages and the labor force declines it is optimal
to reduce the capital with which these fewer workers work. The aging of the pop-
ulation brings about a “capital deepening” which is reflected by an increase in the
capital-labor ratio of around 0.6-2% over the projection period. As the aging of so-
ciety shifts the age composition of the population towards older households that (on
average) hold a larger amount of assets, capital becomes relatively abundant, while
labor, also due to the slower growth in the arrival of new workers, becomes scarce.
The higher capital-labor ratio reduces the need for firms to invest in new physical
capital. Thus investment rates fall. The movement of real factor prices is reflected
by the varying relative scarcities of factors of production during the demographic
transition. We observe that the real capital rental rate is projected to fall by 0.5% in
2010 and about 1.3% in 2050. Real wages follow almost exactly the inverse path of
the rate of return to capital.
Table 4.4 Impact of population aging on key aggregate statistics (benchmark model)
Variable / Year 2005 2010 2015 2020 2030 2040 2050

Output per capita (%) -0.31 -1.30 -2.02 -2.64 -3.62 -5.79 -6.60
Effective labor supply (%) -0.37 -1.73 -2.63 -3.99 -7.63 -12.15 -16.96
Capital-labor ratio (%) 0.63 1.76 1.83 1.88 1.85 2.08 1.78
Interest rate (%) -0.21 -0.51 -0.49 -0.54 -0.83 -1.03 -1.10
Real wage rate (%) 0.23 0.56 0.58 0.68 1.03 1.24 1.29
Investment-output ratio (%) -3.41 -9.55 -12.97 -16.34 -19.74 -23.75 -26.28
Consumption per capita (%) 0.10 0.70 -0.26 -0.44 -0.39 -0.16 -0.01
Consumption-output ratio (%) 0.32 1.39 1.80 2.25 3.35 5.98 9.22
Note: Results refer to percentage changes with respect to the base year 2003. Output is defined as
the sum of domestic sectoral production. Real factor prices are deflated by the consumption price
index. Consumption comprises private and government consumption.
4.4.2 Sectoral Change During the Demographic Transition
This section analyzes the impact of population aging at the sectoral level. In the
benchmark model, we do not consider age-specific preferences, and hence the ef-
fects on sectoral output induced by population aging are merely driven by supply
side factors which result from the decline in the effective labor supply and the “cap-
ital deepening” process. It is evident that the demographic transition induces sig-
Table 4.5 Sectoral change due to population aging (benchmark model)
Sector / Year 2005 2010 2015 2020 2030 2040 2050

Agriculture and Fisheries 0.61 1.92 2.04 1.88 0.81 0.93 0.74
Mining -0.40 -1.30 -1.74 -2.12 -2.33 -3.11 -3.93
Food Products 0.82 2.55 2.84 2.81 1.73 2.04 1.96
Textiles and Leather Products 2.41 6.49 8.81 11.11 13.13 14.51 13.38
Printing and Publishing 0.03 0.10 -0.06 -0.31 -0.88 -1.25 -1.76
Mineral and Chemical Products -0.20 -0.74 -0.92 -1.01 -0.83 -1.25 -1.78
Metals -1.12 -3.54 -4.15 -4.68 -5.10 -7.17 -9.38
Machinery -1.00 -3.24 -3.61 -3.90 -4.08 -6.09 -8.41
Personal Goods -0.10 -0.21 -0.57 -1.13 -2.41 -3.22 -4.22
Construction, Energy, and Water -3.03 -8.49 -11.57 -14.61 -17.68 -21.25 -23.51
Wholesale and Retail Trade 0.26 0.85 0.83 0.62 -0.25 -0.43 -0.81
Transportation and Communication 0.22 0.67 0.73 0.65 0.10 -0.04 -0.35
Banking and Insurance Services 0.33 1.05 1.13 1.02 0.31 0.36 0.28
Real Estate Services -0.18 -0.41 -0.63 -1.00 -1.86 -2.38 -2.85
Public Services -0.20 -0.07 0.05 0.55 2.86 6.20 11.84
Education -0.24 -0.02 0.29 1.34 5.60 11.04 19.98
Health -0.18 0.21 0.59 1.59 5.41 10.66 19.29
Note: Figures refer to percentage changes in the sectoral share of output in total domestic output
relative to the base year 2003. An increase in the share of sectoral output from one period to another
means that this particular sector is growing faster / decreasing less rapidly than total domestic
production.
nificant changes in the sectoral composition of output. Changes in output shares in

2010 range between −8.49% and +6.49%, and are even more pronounced in 2050
ranging between −23.51% and +19.98%. Among the sectors that benefit most from
varying relative factor endowments due to population aging are Public Services, Tex-
tiles and leather products, Education, and Health. Output shares for the latter two
sectors increase by almost 20% between 2003 and 2050. The sectors that contract
most, relatively, to total domestic output are Metals, Machinery (around −10%) and
Construction, Energy, and Water (−23.51%). Personal Goods, Mining, and Real Es-
tate Services contract by less (around −2% to −4%). Output shares for the remain-
ing sectors Mineral and Chemical Products, Food products, Printing and Publishing,
Wholesale and Retail Trade, Transportation and Communication, and Banking and
Insurance Services change by a relatively small extent (around −1.7% to +1.7%).
The expansion/contraction of sectors can be explained by looking at the evo-

lution of sectoral employment of capital and labor (Table 4.6). As evident from
the discussion of the macroeconomic effects, population aging brings about an in-
crease in the economy-wide capital-labor ratio. Since the magnitude of the overall
demographic shock—recall that aggregate effective labor supply falls by 16% until
2050—is significant, we consequently find that the capital-labor ratio in each single
sector increases, too (results not shown). To get an intuition for why some sectors
benefit and others contract, it is therefore necessary to look at how quantities of
labor and capital used in production evolve over time relative to aggregate labor sup-
ply and the capital stock. Looking at these statistics indicates which sectors employ
most productively abundant capital and attract scarce labor. Note that in Table 4.6
an increase in the sectoral share of labor in aggregate effective labor means that the
contraction of labor that is being employed in this sector is smaller than the overall
decline in aggregate labor supply that occurs due to population aging. Similarly, an
increase in the sectoral share of capital implies that the quantity of capital used in
this particular sector grows faster than the economy-wide capital stock.
Consequently, all sectors which benefit from population aging are characterized
by an increase in both the share of sectoral employment of capital and labor; e.g.,
the share of employment of labor in Health monotonically rises from 5.17% in 2005
to 6.12% in 2050, an increase by almost 20%. Capital usage in this sector also in-
creases over the projection horizon by 20% from 3.90% in 2005 to 4.70% in 2050. A
faster decrease of sectoral labor employment relative to the decline in the aggregate
labor supply in conjunction with a steadily decreasing share of sectoral capital in
the economy-wide capital stock explains why sectoral output shares for, e.g., Metals,
Machinery, Personal Goods, and Construction, Energy, and Water decline between
2005 and 2050. The patterns of sectoral activity for sectors that first expand and then
contract can also be explained by referring to Table 4.6. In line with the evolution
of the sectoral output share, e.g., the share of employment in Wholesale and Retail
Trade first slightly increases from 16.27% in 2005 to 16.50% in 2015, but is then
declining until 2050 and drops to 16.16%. A similar qualitative pattern is observed
for the evolution of the capital share in this sector.
Overall, the sectoral change that is due to supply side factors induced by popu-
lation aging, i.e. the decrease in labor supply and the “capital deepening” process,
produces quantitatively substantial effects. We will turn back to this issue in Section
4.5.1 in which we aim to quantify the demand side effects of population aging that
result from age-specific preferences.20
20 As the study by Fougere et al. (2007) is the only point of reference for the type of analysis
presented here, a couples of remarks are in order. It is important to bear in mind that both mod-
els differ along various dimensions. One major difference is that in their model labor supply is
exogenous whereas the present model features a labor-leisure trade off. Given that the evolution of
aggregate labor supply is a key driver of results, this certainly complicates a comparison. Further-
more, the quantitative nature of the demographic process, which is the major exogenous driving
force of the model, the numerical specification of age-specific preferences, and the underlying
Input-Output data are quite different for Germany and Canada. Notwithstanding these considera-
tions, the macroeconomic predictions of both studies are qualitatively similar. To see this, compare
Table 4.4 with Table 9, p. 705, in Fougere et al. (2007). Due to differences in the sectoral aggrega-
4 Quantifying the Sectoral and Distributional Effects of Demographic Change in Germany
Table 4.6 Impact of population aging on sectoral employment and capital use
Share of sectoral employment in aggregate labor (in %) Share of sectoral capital in aggregate capital (in %)
Sector / Year 2005 2010 2015 2020 2030 2040 2050 2005 2010 2015 2020 2030 2040 2050
AGF 0.664 0.678 0.680 0.680 0.673 0.674 0.670 1.663 1.688 1.694 1.696 1.682 1.685 1.679
MIN 0.612 0.611 0.609 0.608 0.606 0.602 0.594 0.185 0.184 0.184 0.184 0.184 0.183 0.181
FOP 1.884 1.925 1.933 1.934 1.907 1.910 1.898 1.268 1.302 1.309 1.314 1.312 1.323 1.322
TXL 1.078 1.129 1.160 1.191 1.216 1.231 1.210 0.474 0.500 0.514 0.530 0.550 0.562 0.555
PRP 2.212 2.225 2.225 2.222 2.203 2.192 2.170 1.802 1.817 1.819 1.821 1.825 1.826 1.816
MIC 5.296 5.294 5.295 5.296 5.292 5.262 5.206 3.301 3.316 3.319 3.332 3.374 3.379 3.361
MET 5.061 4.958 4.937 4.914 4.877 4.762 4.622 2.567 2.530 2.521 2.519 2.534 2.493 2.434
MAC 20.173 19.822 19.836 19.848 19.809 19.362 18.751 6.475 6.433 6.441 6.477 6.588 6.510 6.346
PGO 0.766 0.769 0.768 0.764 0.752 0.745 0.733 0.344 0.347 0.347 0.346 0.346 0.345 0.341
CEW 4.919 4.674 4.524 4.374 4.213 4.029 3.895 4.666 4.414 4.276 4.140 4.001 3.831 3.717
WRT 16.271 16.480 16.504 16.489 16.331 16.300 16.161 8.335 8.404 8.423 8.426 8.373 8.365 8.324
TRC 5.598 5.664 5.677 5.680 5.645 5.638 5.594 6.115 6.159 6.178 6.190 6.172 6.170 6.144
BIN 4.774 4.844 4.855 4.856 4.819 4.822 4.796 3.614 3.649 3.661 3.666 3.649 3.655 3.648
RES 10.915 10.980 10.972 10.947 10.856 10.809 10.708 48.40 48.42 48.43 48.37 48.08 47.88 47.59
PBS 9.790 9.867 9.894 9.954 10.169 10.497 11.001 6.246 6.267 6.289 6.336 6.494 6.709 7.057
EDU 4.824 4.862 4.885 4.940 5.136 5.397 5.803 0.640 0.642 0.646 0.654 0.682 0.718 0.774
HEA 5.163 5.218 5.245 5.303 5.495 5.768 6.188 3.902 3.925 3.949 3.998 4.156 4.367 4.702
Note: The relative expansion/contraction of sectors induced by population aging as indicated by the changes in sectoral output shares (see Table 4.5) can be
explained by looking at the evolution of shares of sectoral employment and capital use. Whether a sector expands/contracts depends on how factors of
production evolve over time relative to aggregate labor and capital. The statistics displayed above indicate which sectors most productively employ abundant
capital and attract scarce labor. An increase in the sectoral share of labor in aggregate labor means that the contraction of labor that is being employed in this
sector is smaller than the overall decline in aggregate labor supply that is due to population aging. An increase in the sectoral share of capital implies that the
quantity of capital used in this sector contracts less than the economy-wide capital stock.
108
4.4.3 Distributional and Welfare Consequences of the

Demographic Transition
In the previous sections we have documented substantial changes in factor prices

induced by the aging of the population, amounting to a decline of about 1.1% in the
real return to capital and an increase in the real wage rate of about 1.3% until 2050.
In this section we aim to quantify the distributional and welfare effects arising from
these factor price changes.
4.4.3.1 Evolution of Inequality
To characterize the evolution of income inequality over the projection period we

compute Gini coefficients21 for three different (sub-)sets of households: first, the
Gini coefficient labeled “all households” uses income observations for households
across generations and household types that are alive at time t, second, “intergen-
erational” looks at the impact on the intergenerational dispersion of income (for a
given household group), and, third, intragenerational computes the Gini coefficient
that measures the evolution of inequality within a particular household group (for a
given generation).
Figure 4.4 displays the evolution of income inequality for total income, labor in-
come and capital income which is derived from financial wealth for all households.
Total income comprises labor income, transfer income, and capital income. Look-
ing at the distribution that includes agents of different age and type, we observe a
significant increase in total income inequality from 0.59 in 2005 to 0.64 in 2050, an
increase in the Gini coefficient of about 8.4%. Inequality increases although labor
income inequality declines over the same horizon from 0.58 in 2005 to 0.53 in 2050
because the dispersion in capital income rises by around 4% from 0.73 in 2010 to
0.76 in 2050.
Both, the evolution of inequality for capital and labor income is mainly due
to the impact of the demographic transition on the respective intergenerational
distribution—changes in inequality within a generation are very little. Figure 4.5 dis-
tion of industries and the aforementioned quantitative differences in input data, comparing results
at the sectoral level is not instructive.
21 The Gini coefficient is a summary statistic of the Lorenz curve, and is here calculated as the
relative mean difference, i.e. the mean of the difference between every possible pair of observations
(xg,h,t , xg0 ,h0 ,t ) of a generation g and household type h at a given point in time t relative to the size
of the mean:
n + 1 ∑{g,g0 } ∑{h,h0 } |xg,h,t − xg0 ,h0 ,t |
Gt = . (4.45)
n 2n2 µt
Here, n denotes the total number of households alive at t and µt is the arithmetic mean. The Gini
coefficient ranges from a minimum value of zero, when all individuals have equal income (the
numerator in (4.45) then equals zero), to a theoretical maximum of one in an infinite population
in which all income is concentrated in one hand (to see this, divide (4.45) by 2n2 , substitute the
numerator by an expression which depends on the number of non-zero pairs, and apply l’Hôpital’s
rule as n → ∞).
0 ,8
0 ,7
G in i c o e ffic ie n t
0 ,6
0 ,5
G in i c o e ffic ie n t fo r to ta l in c o m e
0 ,4 G in i c o e ffic ie n t fo r c a p ita l in c o m e
G in i c o e ffic ie n t fo r la b o r in c o m e
0 ,3
2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0
Y e a r
Fig. 4.4 Evolution of income inequality (all households)
Note: Gini coefficients are calculated on the basis of the entire sample which comprises households
across different types and time.
plays the Gini coefficients that are based on samples of income observations which
pool households across time for a given household type. Inequality of the intergen-
erational capital income distribution increases by around 18% (for h = 1 from 0.53
in 2005 to 0.63 in 2050) and the pattern of the increase is similar to the evolution
of the corresponding Gini coefficient in Figure 4.4 (Gini coefficients for different
household types move in parallel, hence only those for h = 1 and h = 8 are shown).
The reason for the increase in intergenerational capital income inequality—which
ultimately drives the evolution of total income inequality—is that older households
hold more assets than younger households. Since capital income is proportional to
wealth, and as the demographic transition induces a shift towards older, asset-rich
households, capital inequality is bound to increase. Impacts on the intragenerational
distribution of capital income are minor (not shown).
The decline in inequality of the intergenerational labor income distribution
(again, a similar pattern is observed for different household types) stems from the
significant drop in aggregate labor supply which induces a continuous rise in the
real wage rate. Steadily increasing returns to labor diminish the role played by la-
bor productivity over the life cycle in shaping labor supply decisions: households
face a trade-off between supplying labor in middle ages when their productivity is
high and wages are low and supplying labor in older ages when labor productivity
is relatively low but wages have increased. Labor supply over the life cycle still
follows a hump-shaped pattern but the increase in wage rates in the course of the
0 ,8
G in i c o e ffic ie n t fo r c a p ita l in c o m e (h = 1 )
G in i c o e ffic ie n t fo r c a p ita l in c o m e (h = 8 )
0 ,7 G in i c o e ffic ie n t fo r la b o r in c o m e (h = 1 )
G in i c o e ffic ie n t fo r la b o r in c o m e (h = 8 )
0 ,6
0 ,5
0 ,4
0 ,3
0 ,2
0 ,1
2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0
Y e a r
Fig. 4.5 Evolution of intergenerational income inequality
Note: Gini coefficients are calculated on the basis of a subset of households which comprises
households of different generations but holds fixed a particular household type
projection period implies a tendency for a “flatter” labor income profile. This effect
explains the significant drop in intergenerational inequality of labor income from
0.28 in 2005 to 0.15 in 2050.
In our model, population aging has a minor impact on the intragenerational in-
equality of labor income over the life cycle. Figure 4.6 plots the evolution of the
Gini coefficient over the lifetime of a generation. Not surprisingly, the dispersion of
labor income within a generation follows the hump-shaped profile of labor produc-
tivity over the life cycle: increasing wages magnify intra-cohort differences in labor
productivity and hence increase labor income inequality.
Overall, however, intergenerational rather than intragenerational factors account
for the evolution of capital and labor income inequality. Since intergenerational eq-
uity decreases the dispersion of the dispersion of the income distribution during the
demographic transition increases.
4.4.3.2 Welfare Consequences of the Demographic Transition
Due to the demographic transition lifetime utility of a household changes because

he faces different factor prices than without changes in the demographic structure.
Specifically, households face a path of declining interest rates and increasing wages,
relative to a situation without population aging. How do these opposite movements
0 ,5 0 0
G in i c o e ffic ie n t fo r la b o r in c o m e (g = 2 0 0 5 )
0 ,4 9 8 G in i c o e ffic ie n t fo r la b o r in c o m e (g = 2 0 1 0 )
0 ,4 9 2
0 ,4 9 0
0 ,4 8 8
0 ,4 8 6
0 ,4 8 4
0 ,4 8 2
2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0
Y e a r
Fig. 4.6 Evolution of intragenerational income inequality
Note: Gini coefficients are calculated on the basis of a subset of households which comprises
households of different types but holds fixed a particular generation.
of factor prices affect welfare? How are welfare gains and losses distributed inter-
and intragenerationally?
For welfare comparison we solve each household’s problem under two different
scenarios. Let denote paging the vector of equilibrium prices as documented in the
previous section. Alternatively, consider a “no aging”-scenario where prices are held
constant at their 2003 value, and let pno aging denote this hypothetical price situation.
As the basis of comparison we use the Hicksian equivalent variation (EVg,h ) which
measures the percentage change in lifetime income that would be equivalent to the
price change as implied by the demographic transition in terms of the impact on
lifetime utility. Using the indirect utility function we can write more formally:

vg,h incno aging,g,h (1 + EVg,h ) , pno aging = vg,h incaging,g,h , paging (4.46)
where incno aging,g,h and incaging,g,h denote lifetime income under the respective sce-
nario. Positive numbers of EVg,h indicate that households obtain welfare gains from
the general equilibrium effects of the demographic changes, negative numbers imply
welfare losses.
Table 4.7 documents these numbers for generations that are alive in 2003. We
make several observations. First, newborn agents experience massive welfare gains
from changing factor prices induced by the demographic transition equivalent of
more than 14% in lifetime income. The demographic transition induces a substan-
tial increase in real wage rates and a future path of declining interest rates. The
dominating effect for newborns is the substantial increase in wage rates because
these agents have not yet accumulated financial wealth and thus do not suffer from a
loss of capital income on already accumulated financial wealth, in contrast to older
4.5 Sensitivity Analysis 113
Table 4.7 Welfare consequences of population aging (equivalent variation in %)
generation h=1 h=2 h=3 h=4 h=5 h=6 h=7 h=8

born in
2003 14.7 16.7 18.9 20.4 22.4 23.7 24.3 25.2
1995 13.8 15.4 17.1 18.4 20.1 21.1 21.6 22.4
1990 12.2 13.5 15.1 16.2 17.6 18.6 19.0 19.7
1980 5.0 5.8 6.7 7.4 8.2 8.8 9.1 9.5
1970 1.1 1.5 1.9 2.2 2.6 2.9 3.0 3.3
1960 -0.5 -0.4 -0.2 -0.1 0.0 0.1 0.2 0.3
1950 -0.5 -0.5 -0.4 -0.4 -0.3 -0.3 -0.3 -0.3
households. Of course, lower returns to capital make it more difficult to accumulate

assets to finance old-age consumption. This effect, however, is largely dominated by
increases in labor income. Second, positive welfare consequences for agents alive
in 2003 decrease substantially with age, and even turn negative for households born
before 1960. Due to relatively low labor productivity in old age, these agents do
not benefit from increases in wages but, on the other hand, face lower interest rates
on their already accumulated asset stock. This drives down capital income and de-
presses consumption, and hence welfare decreases. This pattern of intergenerational
welfare impacts is stable across different types of households. Third, given that the
welfare impact is largely driven by increasing wages, it is not surprising that those
members of society for whom labor income constitutes a smaller part of (future) re-
sources benefit less from the demographic transition. Recall that a major source for
heterogeneity of households within a generation is labor productivity. High-skilled
type h = 8 households consequently benefit almost twice as much from the demo-
graphic transition relative to least productive type h = 1 households.
4.5 Sensitivity Analysis
In this section we discuss how the results derived from the benchmark model hinge
on a number of structural model assumptions as well as on the numerical specifica-
tion of key model parameters. More specifically, we want to assess the quantitative
importance of structural changes in old age consumption that are a result of age-
specific preferences. Futhermore, by means of piecemeal sensitivity analysis, we
identify key model parameters that decisively influence the nature and strength of
the economic adjustment.
Table 4.8 Age-specific distribution of consumer spending across sectoral goods
Sectoral good < 25 25-35 35-45 45-55 55-65 65-70 70-80 80+
AGF 0.021 0.021 0.022 0.022 0.021 0.022 0.022 0.021
MIN 0.015 0.015 0.015 0.015 0.015 0.015 0.017 0.019
FOP 0.177 0.171 0.182 0.181 0.172 0.173 0.174 0.169
TLX 0.064 0.062 0.062 0.060 0.056 0.054 0.052 0.046
PRP 0.027 0.028 0.030 0.029 0.030 0.032 0.032 0.029
MIC 0.069 0.075 0.072 0.077 0.079 0.078 0.071 0.067
MET 0.005 0.005 0.005 0.005 0.006 0.006 0.005 0.005
MAC 0.093 0.100 0.095 0.099 0.096 0.092 0.077 0.065
PGO 0.027 0.029 0.030 0.029 0.031 0.032 0.030 0.029
CEW 0.036 0.036 0.036 0.035 0.037 0.038 0.041 0.045
WRT 0.021 0.023 0.022 0.023 0.021 0.019 0.015 0.011
TRC 0.086 0.072 0.062 0.063 0.055 0.050 0.045 0.039
BIN 0.027 0.027 0.027 0.028 0.029 0.028 0.030 0.039
RES 0.240 0.235 0.238 0.232 0.244 0.247 0.270 0.297
PBS 0.061 0.063 0.065 0.063 0.065 0.068 0.069 0.068
EDU 0.015 0.017 0.017 0.011 0.007 0.005 0.004 0.003
HEA 0.015 0.019 0.021 0.027 0.036 0.041 0.046 0.048
Note: Own calculations based on the German Income and Expenditure survey (Einkommens- und
Verbrauchstichprobe) 2003 and a ”z-matrix (Konsumverflechtungstabelle), both Federal Statistical
Office of Germany.
4.5.1 Age-specific Preferences: How Important Are Structural

Changes in Final Consumption Demand ?
Apart from the most direct effect of population aging, the substantial decline in the
supply of effective labor, a second demand-side induced effect may be important.
Empirical data for Germany suggests that the composition of consumer spending
varies with age.
Table 4.8 displays the age-specific distribution of spending shares across the 17
sectors in the model.22 Most notably, spending shares for Health, Construction, En-
ergy, and Water, and Banking and Insurance Services rise with age. The spending
share on Health goods is three times larger for households aged 80 and older than for
the youngest age group. Spending shares for Education, Transport and Communica-
tion, Food Products, Wholesale and Retail Trade, and Textiles and Leather Products
decline with age. Given the variation of spending shares with age for a number of
22 The numbers in Table 4.8 are based on household data from the German Income and Expenditure
Survey 2003 (Einkommens- und Verbrauchsstichprobe) issued by the Federal Statistical Office of
Germany. The original data lists age-specific consumer spending by consumption categories that,
however, do not match with the sectoral structure of our model. The age-specific distribution of
spending shares across sectoral goods can be recovered using a so-called “Z-matrix” or “bridge-
matrix” that maps consumer spending from the consumption categories to the 71 industries of the
German Input-Output table.
sectors, one might therefore expect additional changes in the sectoral composition
of output as the population shifts towards older people.
This view is supported by Lührmann (2005) who estimates age-specific house-
hold demands for a set of eight composite goods using a quadratic almost ideal de-
mand system based on EVS data.23 On the contrary, a study by Schaffnit-Chatterjee
(2007)—which is however based on a crude back-of-the envelope calculation—finds
that the expenditure shares of consumption categories in aggregate expenditures are
not significantly influenced by population aging. The present study is the first at-
tempt in the literature to quantify these effects using a comprehensive general equi-
librium model.
One remark is in order. The measurement of age-specific consumption behavior
is more complicated than Table 4.8 suggests. As these age-specific spending shares
are calculated on the basis of cross-sectional data, they confound age, cohort, and
time effects. Unfortunately, there is no suitable panel data for Germany available
to address this problem. However, looking at repeated cross-sections Börsch-Supan
(2003) finds that these age-consumption profiles did not change much over the past
20-25 years—hence cohort effects appear to be small and probably do not bias Ta-
ble 4.8 to a substantial extent. Assuming that the pattern of age-specific spending
remains much the same in the future, we are able to compute the adjustment path
for an economy where households’ preferences vary with age. As in the benchmark
model, we assume that households of different type have the same preferences.24
Table 4.9 suggests that accounting for age-specific preferences has only minor ef-
fects in terms of the macroeconomic consequences of the demographic transition.
A comparison with the results displayed in Table 4.4 reveals that all key aggre-
gate statistics move in the same direction. This underlines that the nature of the
economic transition is predominantly shaped by the negative labor supply shock.
Also, from a quantitative viewpoint, both models produce very similar results: in
the model with age-specific preferences, output per capita and effective labor sup-
ply decline slightly more, movements in real factor prices are almost identical, and
the investment-output ratio decreases slightly less whereas the consumption-output
ratio is marginally higher relative to the benchmark model.
On the sectoral level, a similar observation applies. Comparing results in Table
4.10 with the respective sectoral impacts shown in Table 4.5 suggests that whether
a particular sector expands or contracts (relative to total domestic output) is solely
determined by the negative labor supply effect: the pattern of changes in output
23 Her results (compare Table 3, p. 29) suggest significant increases in aggregate expenditure shares
for health (6.6%) and energy (5.3%) and a decline for transport (−7.6%) and leisure (−4.4%). A
major shortcoming of her econometric approach, however, is to ignore possible feedback effects
that stem from changes in relative prices.
24 A remark concerns the calibration of technology parameters which has been carried out under the
benchmark household preference structure. As we use the same values for technology parameters
for this “counterfactual”, the model does not endogenously reproduce the base year values. On the
other hand, recalibrating technologies would change the adjustment of sectoral activity in response
to a demographic shock, and would make a comparison between models difficult. For this reason,
we keep all parameter values—except for those relating to age-sensitive preferences—constant.
Table 4.9 Impact of population aging on key aggregate statistics (model with age-specific prefer-
ences)
Variable / Year 2005 2010 2015 2020 2030 2040 2050

Output per capita (%) -0.51 -1.85 -2.91 -3.84 -5.20 -7.44 -8.13
Effective labor supply (%) -0.61 -2.39 -3.59 -5.13 -8.81 -13.27 -18.00
Capital-labor ratio (%) 0.72 1.98 2.13 2.20 2.08 2.26 1.96
Real capital rental rate (%) -0.11 -0.27 -0.36 -0.49 -0.63 -0.85 -1.09
Real wage rate (%) 0.20 0.46 0.42 0.49 0.80 1.02 1.08
Investment-output ratio (%) -3.21 -8.86 -11.87 -14.78 -17.54 -21.23 -23.88
Consumption-output ratio (%) 0.59 2.17 3.13 4.10 5.01 7.72 9.80
Note: Results refer to percentage changes with respect to the base year 2003. Output is defined as
the sum of domestic sectoral production. Real factor prices are deflated by the consumption price
index. Consumption comprises private and government consumption.
shares across sectors and time that is obtained from the model with age-specific
preferences is roughly identical to the pattern obtained from the benchmark model.
From a quantitative viewpoint, however, demand side induced effects do matter.
Most obvious, quantitative differences between both models are due to a direct ef-
fect that stems from age-related consumer demand. For instance, the age-specific
increase in the spending share of Health as shown in Table 4.8 translates into an
increase in the respective output share as compared to the benchmark model. Direct
demand side effects that are in line with the movement of age-specific spending
shares are also observed for a number of other sectors, e.g., Public Services, Real
Estate, Banking and Insurance Services, Construction, Energy, and Water. Sectoral
activity is, however, also indirectly affected by changes in intermediate demand.
This explains why sectoral output shares for some sectors do not move in the direc-
tion one might expect from looking at spending shares in Table 4.8. For instance,
output shares for Wholesale and Retail Trade increase relative to the benchmark
model although consumer spending shares diminish with age. Table 4.13 displays
input-output data which underlies the sectoral model structure. Looking at column
“WRT” reveals which sectors use Wholesale and retail trade products and services
as an intermediate input in production. Sectors that heavily rely on Wholesale and
Retail Trade products, i.e. FOP, TRC, RES, PBS, are exactly those that exhibit an
increase (a less strong decline) in sectoral output shares relative to the benchmark
model.
Overall, we can summarize that accounting for structural changes in life-cycle
consumption that are due to age-specific preferences does not affect the qualitative
results of the benchmark model. Quantitative effects on the aggregate economy level
are relatively small. The reason for this is that total consumption expenditures by
older households (aged 60-74) only make up 24% of total private consumption in
2003, and do not exceed 30% in 2050. This suggests that the level and the growth of
old age consumption are both not large enough to translate compositional effects in
household consumption into significant economy-wide effects. For this to happen,
either a more sizable shift towards older people in the population or a higher level
of old age consumption per se would be required. In contrast, quantitative effects
on the sectoral level are significant. The presence of intermediate demand linkages
implies, however, that for some sectors the pattern of changes in sectoral output
shares is not in line with the movement of age-dependent spending shares.
Table 4.10 Sectoral change due to population aging (model with age-specific preferences)
Sector / Year 2005 2010 2015 2020 2030 2040 2050

Agriculture and Fisheries 1.06 3.14 3.79 3.99 3.14 3.28 2.96
Mining -0.12 -0.47 -0.81 -1.10 -1.44 -2.01 -2.83
Food Products 1.33 3.93 4.82 5.18 4.29 4.56 4.26
Textiles and Leather Products 1.84 4.93 6.23 7.33 7.67 8.41 7.74
Printing and Publishing 0.20 0.55 0.57 0.47 0.04 -0.24 -0.78
Mineral and Chemical Products -0.05 -0.31 -0.54 -0.66 -0.64 -0.93 -1.48
Metals -1.29 -3.94 -4.81 -5.41 -5.82 -7.64 -9.85
Machinery -1.20 -3.75 -4.44 -4.83 -5.03 -6.79 -9.09
Personal Goods 0.05 0.18 0.12 -0.15 -1.04 -1.77 -2.81
Construction, Energy, and Water -3.02 -8.31 -11.17 -13.95 -16.56 -20.00 -22.41
Wholesale and Retail Trade 0.36 1.10 1.35 1.37 0.86 0.72 0.34
Transportation and Communication 0.28 0.81 1.04 1.13 0.86 0.77 0.45
Banking and Insurance Services 0.14 0.46 0.59 0.62 0.47 0.53 0.59
Real Estate Services -0.04 -0.03 -0.01 -0.14 -0.68 -1.08 -1.57
Public Services -0.16 0.03 0.41 1.25 4.36 8.22 14.65
Education -0.28 -0.13 0.41 1.82 7.13 13.38 23.61
Health -0.28 0.31 0.73 2.31 7.95 14.73 25.90
Note: Figures refer to percentage changes in the sectoral share of output in total domestic output
relative to the base year 2003. An increase in the share of sectoral output from one period to another
means that this particular sector is growing faster (decreasing less rapidly) than total domestic
production.
4.5.2 Piecemeal Sensitivity Analysis
Table 4.11 shows the effects of changing key model parameters from the base case
parametrization of Section 4.3. For ease of reference, base case results are displayed
in the first row of Table 4.11. For each parameter that is used in the sensitivity analy-
sis, we report results for one value that is below and one value that is above the base
case. Table 4.11 documents that changing parameter values can produce perceivable
quantitative effects. Most importantly, however, it is found that all qualitative model
results are preserved.
Since the negative labor supply shock significantly drives the overall results, pa-
rameters that govern labor supply decisions of households are found to have the
greatest impact. A lower value for the intertemporal elasticity of substitution means
that households are less willing to tolerate fluctuations in consumption over their life
cycle. Given decreasing interest rates which make it harder to accumulate wealth
(and earn capital income), a higher degree of consumption smoothing can only be
achieved if labor supply is more elastic. Hence, in light of increasing wage rates
along the demographic transition, lower values for σh imply a weaker contraction in
aggregate labor supply. A lower value of the intratemporal elasticity of substitution
between leisure and consumption makes labor supply less elastic, and hence the de-
crease in aggregate labor supply is more pronounced. Similarly, a lower weight on
material consumption (a larger weight on leisure) in instantaneous utility implies
that labor supply is less sensitive to changes in the wage rate. The extent of the con-
traction in output per capita for different values of these three household parameters
can therefore be explained by movements in aggregate labor supply.
A lower value for the capital depreciation rate stimulates capital accumulation
and somewhat mitigates the decline in output per capita. A lower value for δ
strengthens the role of capital accumulation relative to endogenous variations in
labor supply as an adjustment mechanism to the demographic transition. A larger
decrease in aggregate labor supply is therefore consistent with a smaller reduction
in output per capita. Uniformly lowering the elasticity of substitution between capi-
tal and labor in value-added for all sectors by 30% has only minor effects. A lower
degree of substitutability means that firms are flexible in adjusting to a situation
with changing factor price changes, and hence losses in output per capita are slightly
higher.
In terms of the impact on factor price changes, the decrease in the real return to
capital ranges from −0.29% to −0.71% in 2010 and from −0.23% to −1.22% in
2040 for the scenarios considered. Increases in real wage rates lie between 0.30%
and 0.72% in 2010 and between 0.25% and 1.40% in 2050. The evolution of income
inequality as measured by changes in the Gini coefficient is found not to be very
sensitive: increases from 2010 to 2040 range between 7.3 − 10.1%.
The sensitivity of results with respect to the Armington elasticity of substitution
is found to be low. This underlines the overall robustness of results. Recall that the
assumption of imperfect substitutability between domestic and foreign goods im-
plies that the domestic interest rate can deviate during the transition period from
the exogenous world market interest rate; in the limit of perfect substitutability the
domestic interest rate would be exogenous in all periods. As such, σAR,i indirectly
affects the capital accumulation process. A lower value of σAR,i means that the econ-
omy cannot rely as much on imported goods to build up its capital stock. This neg-
ative effect is buffered by a smaller decline in aggregate labor supply. Both effects
imply that the capital-labor ratio increases by less.
This chapter employs a multi-sectoral OLG model with intra-cohort heterogeneity

to analyze the economic consequences of the demographic transition in Germany.
Table 4.11 Piecemeal sensitivity analysis (benchmark model)
Parameter Output Eff. labor Cap.-labor Real return Real wage Gini coeff. EVb
per capitaa supplya ratioa to capitala ratea income
2010 2040 2010 2040 2010 2040 2010 2040 2010 2040 2010 2040
Base case parametrizationc -1.30 -5.79 -1.73 -12.15 1.76 2.08 -0.51 -1.03 0.56 1.24 0.582 0.639 14.71
σh = 0.60 -0.15 -1.42 -1.15 -10.97 1.46 1.56 -0.56 -1.23 0.62 1.47 0.584 0.641 14.62
Intertemporal ES
σh = 0.99 -2.12 -8.10 -2.69 -14.03 2.28 2.78 -0.39 -0.50 0.42 0.57 0.580 0.635 12.22
νh = 0.60 -2.29 -7.97 -2.84 -13.70 2.32 2.61 -0.29 -0.23 0.30 0.25 0.618 0.664 13.92
Intratemporal ES
νh = 0.99 -0.94 -4.89 -1.50 -11.97 1.63 1.98 -0.53 -1.15 0.58 1.37 0.570 0.628 14.15
αh = 0.40 -2.53 -8.57 -3.47 -14.49 2.79 2.85 -0.71 -0.65 0.72 0.67 0.587 0.641 11.92
Consum. share param.
αh = 0.80 -0.84 -5.40 -0.85 -11.53 1.11 1.55 -0.37 -1.15 0.44 1.40 0.576 0.633 14.37
δ = 0.025 -0.95 -4.72 -1.96 -12.71 1.82 1.93 -0.49 -0.76 0.53 0.93 0.583 0.641 14.69
Cap. depreciation rate
δ = 0.035 -1.43 -6.07 -1.43 -11.34 1.62 1.90 -0.49 -1.22 0.52 1.36 0.589 0.632 11.60
low -1.40 -6.13 -1.69 -12.12 1.58 1.62 -0.55 -1.03 0.60 1.24 0.581 0.638 13.53
ES in value-addedd
high -1.25 -5.58 -1.80 -12.23 1.96 2.63 -0.48 -1.02 0.53 1.24 0.582 0.639 13.79
low -1.14 -5.12 -1.26 -11.20 1.48 1.55 -0.43 -0.93 0.50 1.25 0.585 0.640 14.37
ES in Armington productione
high -2.29 -7.98 -2.28 -13.04 1.86 2.01 -0.28 -0.34 0.29 0.38 0.578 0.632 11.58
Note: All results are computed using the benchmark model. ES=elasticity of substitution. a : Numbers refer to percentage change relative to 2003. b : Equivalent
variation in lifetime income (in %) for a newborn generation in 2003 of type h = 1. c : σh = νh = 0.8, αh = 0.6, δ = 0.029. For each parameter, the base case
value lies between the two values used in the sensitivity analysis. d : low (high) refers to a situation where the elasticities of substitution in value-added for all
sectors have been reduced (increased) by 30% relative to the base case parametrization. e : low (high) refers to a situation where the elasticities of substitution in
Armington production for all sectors have been reduced (increased) by 50% relative to the base case parametrization.
119
While the analysis is carried out for Germany, some of the results may be applicable
to other major industrialized countries facing similar demographic transitions.
The contribution of this chapter is twofold. First, we argue that shifts in the
sectoral structure constitute an important channel of adjustment to population ag-
ing. We document that the demographic transition is bound to induce significant
changes in the sectoral composition of output ranging—as measured by changes in
output shares—from −8.49% to +6.49% in the year 2010 and from −23.51% to
+19.98% in 2050. While accounting for structural changes in life-cycle consump-
tion due to age-specific preferences does not affect the qualitative results of the
benchmark model, and has only minor quantitative effects for aggregate variables, it
is found that sectoral effects are quantitatively important. Second, we analyze the dis-
tributional and welfare consequences that follow from factor price changes induced
by the demographic transition. Newborn households in 2003 experience substantial
welfare gains in the order of 14% and more in lifetime income that arise from in-
creases in wages and declines in returns to capital. In contrast, older households that
have already accumulated assets and low-skilled households for whom labor income
constitutes a smaller part of future resources benefit less and may even lose. Income
inequality in Germany is projected to increase due to the demographic transition, as
measured by a 8.4% increase in the Gini coefficient between 2003 and 2050.
While this chapter discloses a number of important channels of economic adjust-
ment to an aging population, it also abstracts from several issues that can play a role
in shaping the economic transition. First, it is important to bear in mind that we oper-
ate in a “frictionless” environment where all endogenous adjustments are driven by
relative price changes. This can only partly be justified by the long-run character of
the analysis. Second, as we do not take a stand on how social security deals with pop-
ulation aging we implicitly assume the presence of a fully-funded private pension
system that operates through the optimal life cycle savings behavior of households.
In this light, the results can be viewed as a benchmark scenario that abstracts from
any public sector-induced distortions to private savings decisions. Third, by adopt-
ing the small open economy assumption we rule out the possibility that differences
in the extent and timing of demographic processes across countries can shape the
economic transition. It has been demonstrated that the presence of globally unsyn-
chronized aging patterns may induce a substantial amount of international capital
flows (see, e.g., Attanasio et al. (2006) and Börsch-Supan et al. (2006)) or can affect
international trade (see Chapter 3). Fourth, although the assumption of imperfect
substitutability between domestic and foreign goods implies that the domestic inter-
est rate can deviate from the exogenous world interest rate, the small open economy
assumption limits the impact of population aging on the interest rate. For exam-
ple, employing multi-region OLG models Börsch-Supan et al. (2006) and Krueger
and Ludwig (2007) find that demographic change tends to reduce the interest rate
by about 0.5-1 percentage points whereas the present model projects a decline of
about 0.2 percentage points over a comparable time horizon. Finally, as suggested
by Ludwig, Schelkle and Vogel (2007), higher returns to labor may make it optimal
for young households to obtain a better education, thereby increasing the supply of
effective labor. Thus, accounting for endogenous human capital accumulation may
mitigate the macroeconomic impact of demographic change.
Appendix 1: Calibrated Share Form
Numerical calculation of economic equilibrium requires the choice of concrete

functional forms for production possibilities and preferences. In applied modeling,
nested constant elasticity of substitution (CES) functions (including Leontief and
Cobb-Douglas specifications as subcases) are most common. Such functions have
certain mathematical properties (regularity) that ease the numerical analysis con-
siderably, but are still flexible enough to allow for an appropriate representation of
economic behavior. CES functions are most easily written in the so-called calibrated
share form, which eases the calculation of free parameters, since it is based on quan-
tities, prices, and value shares that are directly observable from the benchmark data.
Following Rutherford (1995b), the standard CES production function in calibrated
share form reads as: σ
" 1−σ # 1−σ
Y Xi σ
= ∑ θi . (4.47)
Y i Xi
The associated dual cost function in calibrated share form is given by:
" 1
1−σ # 1−σ
cy px,i
= ∑ θi (4.48)
cy i px,i
and demands for the individual factors of production (applying Shepard’s Lemma):
Y cy px,i σ

Xi
= (4.49)
X i Y cy px,i
where Y =output quantity, θi =benchmark value share of Xi in the production of

Y , Xi =input factor, cy =cost of Y , px,i =input price of Xi , and σ =elasticity of
substitution.
Appendix 2: Approximating the Infinite Horizon
In order to solve a finite approximation of the model with a T -period model horizon
(where T is the last period of the numerical model), we use a state variable targeting
approach as suggested by Lau et al. (2002). The post-terminal capital stock (KT)
can be determined as part of the equilibrium calculation by targeting the associated
control variable investment (IT ) in the terminal period. In the present model this is
achieved by adding the following constraint to the model:
IT YAGF,T
= ⊥ KT (4.50)
IT −1 YAGF,T −1
where we use the “⊥” operator to indicate the complementarity aspect. The price
for post-terminal capital (pkt) is determined by a last period version of (4.37):
t H
KT (1 − δ ) + IT = + ∑ ∑ ktg,h,g KT ⊥ pkt (4.51)
g=t−N h=1
where ktg,h,g =assets holdings of terminal generations, i.e. those households that live
beyond T .
Following Rasmussen and Rutherford (2004), government income over the infi-
nite horizon is given by:
1+r 1
gov = p f ,t Tt + ∑ Φt + p f ,0 B − p f ,T B (4.52)
t r r
where the second summand on the right hand side denotes the present value of
future government deficits over the infinite horizon and the third summand gives
the value of terminal assets in the terminal period using the steady-state assumption
to sum over the infinite horizon. Thus, the government agent cannot consume all
of its wealth in the last model period but is “endowed” with a negative amount
of assets that is sufficient to finance future government deficits over the infinite
horizon consistent with a steady state equilibrium at time T . When the government
budget is balanced over the infinite horizon, the terminal level of government assets
is endogenous. This is necessary to account for the fact that a policy change may
cause the government’s asset position in period T to deviate from the baseline level.
Again, following Rasmussen and Rutherford (2004, p.1401), we therefore break
(4.27) into two equations that are imposed on the model as additional constraints:
T
p f ,0 AG,0 + p f ,T AG,T = ∑ (Φt − Γt ) (4.53)
t=0
1
p f ,T AG,T =(ΦT − ΓT ) . (4.54)
r
Equation (4.53) states the required balance within the model horizon as a function
of the endogenous level of terminal assets, AG,T . Equation (4.54) gives the value of
terminal assets as a function of income and expenditure in the terminal period using
the steady-state assumption to sum over the infinite horizon.
Table 4.12 Overview of model parameters
TECHNOLOGY PARAMETERS
βiVA benchmark value share of value-added in total costs
βiL benchmark value share of labor in value-added
χi fixed-coefficient (Leontief) in Armington production
βiIA benchmark value share of intermediate good in investment
βiX benchmark value share of exports
βiH benchmark value share of domestic consumption in domestic production
βiAH benchmark value share of domestic production in domestic consumption
βiAM benchmark value share of imports
tAR,i tax on Armington goods
tY,i output tax in sector sector i
σVA,i elasticity between capital and labor in value-added
σHX elasticity of transformation
σAR,i elasticity of substitution in Armington production
δ annual capital depreciation rate
ΩY,i total factor productivity in production of Yi,t
ΩA,i total factor productivity in production of Ai,t
ΩI total factor productivity in composite investment good
HOUSEHOLD PARAMETERS
r annual steady-state interest rate
θhF benchmark value share of food products
θhNF benchmark value share of non-food products
ϕi,h,t benchmark value share of a single non-food product in non-food aggregate
σh intertemporal elasticity of substitution
νh intratemporal elasticity of substitution between consumption and leisure
κh elasticity of substitution between food and non-food products
σNF elasticity of substitution between non-food products
αh benchmark value share of composite consumption
ρ time preference parameter
πg,h,t labor productivity index over the life cycle
4 Quantifying the Sectoral and Distributional Effects of Demographic Change in Germany
Table 4.13 Intermediate demand structure

AGF MIN FOP TXL PRP MIC MET MAC PGO CEW WRT TRC BIN RES PBS EDU HEA
AGF 72.16 0.42 304.26 2.75 18.03 2.63 0.00 0.00 0.17 0.00 8.08 0.65 0.06 6.50 10.96 0.58 6.77
MIN 3.89 28.36 5.85 0.64 4.57 291.94 30.51 4.22 0.44 80.68 4.35 0.35 0.65 0.87 5.89 1.10 1.88
FOP 42.71 0.00 266.83 0.96 0.00 11.71 0.00 0.00 0.00 0.08 114.09 1.47 0.00 0.12 10.97 3.48 45.40
TXL 1.14 0.17 0.47 79.35 0.31 7.46 1.07 11.79 10.72 3.42 3.73 0.55 0.17 0.28 2.98 0.11 4.96
PRP 1.81 2.38 32.65 6.03 280.75 33.11 11.81 51.42 30.15 60.72 69.57 17.45 10.64 63.84 30.08 11.55 10.30
MIC 44.53 4.66 42.56 33.11 58.88 1017.87 74.69 279.73 19.06 305.81 45.6 68.67 1.32 23.43 27.72 7.99 60.99
MET 3.62 6.92 12.48 1.54 4.46 31.32 697.59 537.76 14.97 112.38 16.52 7.50 0.30 3.19 12.91 0.98 1.78
MAC 11.22 13.82 10.79 3.0 7.06 39.52 46.94 2059.39 5.59 161.55 50.05 71.20 3.94 24.85 63.57 3.75 45.07
PGO 0.01 0.01 0.02 0.65 3.89 3.27 11.16 19.0 34.11 0.3 1.02 0.14 0.15 0.34 8.12 0.61 0.59
CEW 11.9 10.14 28.57 6.57 25.95 58.72 50.6 51.18 4.29 184.69 62.5 31.95 12.6 191.58 61.25 23.09 43.61
WRT 23.83 6.53 88.58 23.15 39.71 84.82 83.97 228.94 32.49 120.43 167.22 75.06 12.97 27.53 67.88 8.59 50.62
TRC 3.11 7.57 54.95 3.0 33.02 74.51 39.35 150.94 9.4 27.36 396.89 751.14 38.76 40.31 71.79 24.93 12.80
BIN 11.83 2.08 16.32 1.76 12.64 28.94 14.85 55.34 3.58 55.35 80.74 58.49 594.24 293.77 99.17 13.8 32.12
RES 50.17 25.51 157.74 12.4 109.67 291.02 96.79 550.94 28.9 311.84 593.57 224.52 426.51 1038.78 249.38 34.27 150.80
PBS 5.61 4.83 18.1 1.49 37.41 35.85 14.11 35.41 2.74 64.26 69.89 24.49 16.1 151.11 274.2 8.26 39.84
EDU 0.49 0.13 1.61 0.28 1.03 3.55 2.32 6.92 0.33 3.42 5.32 3.87 2.93 35.94 11.15 65.28 1.97
HEA 4.72 0.00 0.1 0.00 0.00 0.25 0.00 0.29 0.0 0.0 0.59 0.00 0.00 0.06 1.50 0.48 34.44
Note: Extract of the social accounting matrix (SAM) that shows the intermediate demand structure between sectors. The SAM is based on Input-Output table
1.1, Issue 18(2), Federal Statistical Office of Germany. Original data is aggregated using the sectoral categories as shown in Table 4.2. Figures above refer to
100 Million Euro.
124
Chapter 5
Concluding Remarks
This book presents a new computational method to efficiently solve large-scale

Auerbach-Kotlikoff OLG models that are infeasible for simultaneous solution meth-
ods. The proposed decomposition algorithm is based on the solution of a sequence
of nonlinear complementarity problems. The main idea is to approximate equilibria
of an OLG economy by solving a sequence of representative agent (Ramsey optimal
growth) problems. It has been demonstrated that this algorithm can be used to solve
high-dimensional OLG models that comprise a large number of sectors and regions
and a rich household side, including a large number of heterogeneous households
and a variety of household-specific effects. Given the limitations of integrated ap-
proaches, the new method thus significantly increases the range of economic ques-
tions that can be investigated with these models, providing a valuable addition to
the toolbox of applied general equilibrium modelers. One important advantage of
the decomposition algorithm presented here is that it facilitates the development of
large-scale OLG models designed to investigate in-depth the distributional conse-
quences of economic policy along an intra- and intergenerational dimension.
The usefulness and flexibility of the new approach has been demonstrated by ap-
plying it to various aspects of the macroeconomic analysis of demographic change
that have received little attention in the literature. Chapter 3 develops a dynamic
two-country Heckscher-Ohlin model with overlapping generations to analyze the
consequences of globally unsynchronized aging patterns for international trade and
the distribution of gains from trade under such demographic circumstances. Chapter
4 employs a multi-sectoral OLG model with intra-cohort heterogeneity, calibrated
to the German economy and projected demographic trends, to analyze the conse-
quences of population aging for the sectoral composition of output, and the distribu-
tion of income, wealth, and welfare.
Since the main results have already been summarized in Chapter 1, the remainder
of this chapter provides a discussion of a number of simplifying assumptions that
underly the economic analyses in Chapter 3 and Chapter 4. The following discussion
also serves to highlight possible extensions of the work presented here.
First, all models considered here abstract from government policies. While the
interaction of demographic change and public policies is a wide field, social security

126 5 Concluding Remarks
is clearly a relevant dimension to the analysis. A public pension system can strongly
influence private savings behavior. Consequently, a remarkable number of papers
investigates the adjustments required in the pension system due to demographic
shifts. Important examples include Huang et al. (1997), De Nardi et al. (1999), and
Abel (2003). Krueger and Ludwig (2007) show that the impact on factor prices
induced by the demographic transition is to some extent influenced by the design
and reform of the pension system. Against this background, the results presented in
this book ought to be viewed as a benchmark world in which there is a fully-funded
pension system in place that operates through private life-cycle savings.
Second, the analyses are carried out in a “frictionless” environment in which all
endogenous adjustments are driven by relative price changes. For instance, the as-
sumption of frictionless labor markets may be particularly critical for the European
economies in which unions play an important role in the wage setting process. Also,
the hypothesis of perfect competition on goods markets may not reflect actual mar-
ket structures for particular sectors of the economy. In general, however, accounting
for market frictions is surely more of an issue for an analysis that is—unlike the mod-
els presented in this book—concerned with the short-run effects of the demographic
transition.
Third, it is assumed that demographic dynamics are exogenous to economic de-
velopment. There is a consensus in the literature that in the long run neither fertility
nor mortality are exogenous to economic growth (see, e.g., Barro and Becker (1988),
Barro and Becker (1989), and Boldrin and Jones (2002)). Furthermore, it is plausi-
ble to assume that international migration is endogenous and reacts to international
differences in income.
Fourth, and maybe most critical is the assumption that individuals are fully ratio-
nal and forward-looking. All models presented here assume that household behavior
follows the rational expectations paradigm. While this assumption considerably re-
duces the complexity of the analysis and, from a practical modeling point of view,
enables a relatively simple implementation of household behavior, there are cer-
tainly good reasons to question the rationality of agents. For instance, empirical evi-
dence (for an overview see Attanasio (1999)) shows that households do not smooth
consumption as much as the life cycle theory suggests. At a more general level, the
economic literature on bounded rationality indicates that households sometimes vi-
olate their preferences (Kahneman, 2003). It is an open question of research how
to integrate such behavioral assumptions into a general equilibrium framework. Pos-
sible routes to achieve this are, e.g., to impose additional constraints on household
behavior while maintaining the assumption of full rationality (Altig et al. 2001) or to
depart from this hypothesis by assuming myopic rule-of-thumb behavior (Campbell
and Mankiw, 1991).
Fifth, as suggested by Ludwig et al. (2007), higher returns to labor may make
it optimal for young households to obtain a better education, thereby increasing
the effective supply of labor. Thus, endogenous human capital accumulation may
mitigate the macroeconomic impact of demographic change.
Sixth, the analyses presented here abstract from intergenerational altruism whereby
successive generations are linked through recursive altruistic preferences that give
5 Concluding Remarks 127
rise to intergenerational transfers or bequests. Accounting for such linkages between

generations can mitigate the effects due to population aging as the economic adjust-
ment can be spread over a longer horizon. However, as shown by Altonji, Hayashi
and Kotlikoff (1992), there is strong evidence against the idea that members of ex-
tended families are altruistically linked in a way that would support the infinite
horizon representation as suggested by Barro (1974).
Lastly, abstracting from any form of uncertainty in the model, and assuming ra-
tional expectations on the part of the households, implies that agents have perfect
foresight with respect to future economic and demographic developments. Several
recent papers go beyond a purely deterministic framework and incorporate different
forms of uncertainty in the analysis. Imrohoroglu, Imrohoroglu and Joines (2003)
and Conesa and Krueger (1999) add idiosyncratic uncertainties to study questions
related to social security reform in an OLG context. Using an OLG model with
stochastic production and incomplete markets, Krueger and Kubler (2006) find that
the introduction of an unfunded social security system can lead to a Pareto improve-
ment even when the economy is dynamically efficient. There are, however, virtually
no studies which analyze the consequences of demographic change in an stochastic
OLG framework. A notable exception is Krueger and Ludwig (2007) who employ
a model with uninsurable labor productivity and mortality risk. They find that unin-
surable idiosyncratic uncertainty makes life cycle savings profiles more realistic.
Incorporating uncertainty in complementarity formulations of equilibrium models
is difficult to achieve and is currently on the agenda of some researchers (Böhringer
and Rutherford, 2007).
The previous discussion points out possible extensions for the work presented
here. In summary, the work presented here can be extended in many ways along the
lines discussed above making it possible to investigate new aspects of the economic
consequences of demographic change. Moreover, relaxing a number of simplifying
assumptions may improve the empirical fit of the models and enhance the policy
relevance of the analyses. It is a question for future research whether the inclusion
of those factors would materially alter the results presented here.
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Lecture Notes in Economics

and Mathematical Systems 621

Library of Congress Control Number: 2009922226

© Springer-Verlag Berlin Heidelberg 2009

Cover design: SPi Publishing Services

Printed on acid-free paper

Springer is part of Springer Science+Business Media (www.springer.com)

This book represents a culmination of my Ph.D. research conducted at the Ruhr

Cambridge, Massachusetts, USA

2 Computation of Equilibria in OLG Models with Many

3 Trade Liberalization and Global Demographic Change: A

3.2.2 Firms and Production Structure . . . . . . . . . . . . . . . . . . . . . . . . 50

4 Quantifying the Sectoral and Distributional Effects of Demographic

5 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

3.1 Unsynchronized global aging patterns . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4.1 Evolution of working-age population ratio and population growth rate 82

4.4 Evolution of income inequality (all households) . . . . . . . . . . . . . . . . . . 110

2.1 Convergence performance and approximation error . . . . . . . . . . . . . . . 41

3.1 Base case parametrization of intracohort household heterogeneity . . . 53

4.1 Inequalities and associated complementary variables . . . . . . . . . . . . . . 97

S. Rausch, Macroeconomic Consequences of Demographic Change, 1

computable overlapping generations (OLG) models have emerged as the dominant

goes back to Allais (1947), Samuelson (1958), and Diamond (1965).

be Pareto-optimal: life-cycle savers may overaccumulate capital, leading to equilibria in which

1.2 Macroeconomic Consequences of Demographic Change:

1.2.1 Global Demographic Change and International Trade

1.2.2 Quantifying the Sectoral and Distributional Effects of

Chapter 4 takes a more detailed view of the economic adjustment mechanisms to

found that intergenerational factors, rather than a redistribution between different

applications is available at http://www.mpsge.org.

S. Rausch, Macroeconomic Consequences of Demographic Change, 11

2.2 Calibration in CGE models

2.2.1 CES Preferences

where C denotes the vector of consumption goods Ci , i = 1, . . . , n. There are n + 1

maxc1 ,...,cn U(C)

2.2.2 The Calibrated Share Form

the indirect utility function as:

and by Roy’s identity the demand function as:

share parameters may only be determined up to a scale factor.

2.3 CGE with Many Households: A Decomposition Approach

2.3.1 A Static Economy

Consider the following static economy which is populated by a large number of

2.3.2 A Decomposition Algorithm

Step 0: Initialize the Representative Agent Economy

In the computation of equilibria we will portray the choices of H households us-

Step 1: Solve for a General Equilibrium of the RA Economy

Fig. 2.2 Evaluating household demands at new prices (Step 2)

Step 2: Evaluate Household Demand Functions

Step 3: Recalibrate Preferences of the Representative Agent

Fig. 2.3 Recalibration of preferences (Step 3)

2.4 Convergence Theory

2.4.1 Local Convergence

As explained in Section 2.3.2, the sequential recalibration algorithm iteratively ad-

Local convergence concerns properties of the Jacobian matrix evaluated at the

∂ ζi ∂ di,i ∂ di,i−1 ∂ ζi ∂ di,i−1 ∂ ζi ∂ di,i

demand functions are given by:

The function p(C) is defined implicitly by the equation:

Fig. 2.5 Comparison of SR and tâtonnement fields

g+N t−g 1−1/σh

g+N t−g 1−σ −1